Come together

Pirum’s Phil Morgan reviews the year just gone and casts an eye to the future

As we chalk off another year and digest the collective festive over-indulgence, it is common to reflect on positives, over-analyse on the negatives, but most importantly, consider what our priorities and direction will be for the coming year.

Wide world

The year of 2017 in terms of index performance, was one of the most extraordinary year in the history of the stock market. Investors saw extraordinary returns across the board which were far above the norm. For example, the S&P 500 was up nearly 20 percent this year, which was far above the roughly 8 percent average yearly gains since 1945. Furthermore, daily all-time highs were almost double what had been achieved in previous average years. Equity valuations ascent and its near-record highs were borne from accommodative monetary policy, weak inflation, low interest rates, an improved economic outlook, and increased risk appetite which not only boosted asset prices but also suppressed volatility to the point where the S&P moved greater than 1 percent or more on only eight trading days this year (versus the average since 1945 of 50 days).

The uptick in trade continued to bolster the global economy in 2017. Worldwide expansion has been underpinned by a turnaround in export-oriented sectors and manufacturing activity. Boosted by a recovery in investment, global trade growth rebounded from its slowest pace since 2001 (apart from the recession of 2009) [IMF]. Rising demand for imports, especially from China, over the past year has helped most major countries achieve expanding and increasing export orders, however, potential peaking activity should give slight cause for concern towards the end of 2018.

One notable aspect of 2017’s upswing, is the breadth of growth which accelerated in about three quarters of all countries—the highest share since 2010 [IMF]. The outlook for the global economy in 2018 is a continued but steadier synchronised expansion. There seems a low risk of recession with policy supportive of growth. Although, a shift toward tighter global monetary policy may boost market volatility, underscoring the importance of diversification.

Among the chief global risks for 2018 are potentially counterproductive political movements, especially protectionist measures. Geopolitical risks, such as an escalation of the tensions between the US and North Korea, or business cycle risks, such as an unexpected slowdown in China or the USA, should also not be ruled out.

The eurozone has been experiencing a cyclical and synchronised lift. By far the biggest factor in 2017 was election risk, with the Dutch, German and French populous having their voices heard. The outcome could have called into question the future of the European Union and with it the common currency, especially after the UK’s contrarian activity. The largely pro-Europe election results have rekindled positive sentiment toward the union, however, more recently, events and sentiment in Germany, Spain and Austria suggest we may not be fully out of the woods. The UK, however, remains an outlier and is confronting mounting pressure, as consumers’ expectations deteriorate alongside rising inflation and faltering real income growth not to mention the ‘B-word’.

In late 2017, the ECB and other central banks indicated a wind down of asset purchases in 2018. Towards the end of 2018, we will likely see central bank balance sheets shrink for the first time in many years. This coupled with the likely rise of interest rates during 2018, means that global monetary policy will increasingly become less accommodative.

Nothin’s gonna break my stride

From a securities financing perspective, 2017 can be viewed in some ways as a game of two halves from an asset and time perspective. From an equity perspective global performance in the first half of the year was challenging, especially in Europe and the US, with year on year returns down 20 percent, with the second half of the year showing some positive signs of recovery.

In Europe, equity returns continued to be challenged by the increase of lendable inventory coupled with reduction of single stock outperformance strategies. Asian equities, however, showed strong performance, especially after Q1 with the Japanese market leading the ‘sharp’ improvement.

In the fixed income sector, it was a far rosier picture across corporate and government debt lending, with double-digit percentage year-on-year growth being achieved pretty much across the board. The only regions not achieving significant development were the Asian and emerging markets; probably as a result of their non high-quality liquid assets (HQLA) status. Interestingly, the growth in fixed Income returns was assisted by the lack of inventory build-up seen in equity lending.

In terms of sea-change, 2017 saw the on-loan value of government bonds on-loan eclipse the value of equities on loan for the first time, and, interestingly, much of the growth was against non-cash collateral.

The global value of assets on loan stayed relatively stable throughout 2017 just shy of the €2 trillion mark, as did the value of lendable assets at around €15 trillion. Risk weighting also continues to shape market behaviour with sovereign wealth fund’s providing a large proportion of liquidity to the government bonds markets globally.

Additionally, 2017 saw a marked increase in inter-broker borrowing, presumably driven by a need for efficiency combined by the desire to manage financial resources better. It is likely that facing counterparts with restrictive covenants or high-risk weightings will remain challenging for all but ‘special’ activities throughout 2018.

We’re still standing

For financial services and specifically securities finance, 2017 was a period of uncertainty with regulation including the second Markets in Financial Instruments Directive (MiFID II), Basel III and the Securities Financing Transaction Regulation (SFTR), among others, yet to be completely defined and some only recently implemented.

Basel III recap:

  • Risk coverage: CCR – stricter capital treatment for c/party credit risk (CVA, EPE, CCR, WWR)

  • Tier one capital: rules governing acceptable forms of capital to ensure banks are in a better position to absorb losses (CR)

  • Liquidity: 30-day liquidity coverage ratio (LCR) and a longer-term structural liquidity ratio (NSFR) as well as a common set of monitoring metrics to assist identification and analysis of liquidity risk

  • Leverage: contain the build-up of excessive leverage by introducing safeguards against attempts to ‘game’ risk-based requirements and/or reduce model risk (LR)

  • Cyclicality: counter-cyclical framework to encourage building of capital buffers (CCB)

  • As well as the continuing Basel III impacts, instability will remain in some areas with the outcome of Brexit and the impact of new market rules (especially MiFID II) requiring some time to play out

In other areas, however, including SFTR and NSFR the market seems to be more at ease as they work through the implementation ‘grief curve’ during 2018:

  • Interpretation and impact of regulation

  • Negotiation of regulation

  • Compliance with regulation

  • Strategic adjustments – embed planning/capital-conscious/performance management

  • Business Change – product/business review/client profitability, commercial action/optimise

  • Technical measures – create sustainable IT/process solutions

But be in no doubt, the broader financial services ecosystem is changing considerably. MiFID II will overhaul the trading landscape, with old and new players forging different types of connectivity, particularly through technological innovation and third-party service providers. In securities finance, this is in no way different and arguably more pronounced with the additional and all-encompassing requirements demanded by SFTR.

While SFTR has no financial upside to the industry a potential unintended benefit may be the onset of a new operating model and the widespread adoption of the technology required to deliver it. Change is never easy but the end state should offer a more real-time, interconnected and transparent eco system with the opportunity to do old things better and in some cases, change them entirely. Clearly, institutions not willing or unable to adapt in time could see their business models challenged and should certainly be an area of focus in 2018.

I can see clearly now

The securities financing industry operating model has remained relatively unchanged for a long period of time. During this period of stasis, there was a feeling that if it wasn’t broken then why fix it, but, the model now seems to be evolving and it seems regulation coupled with the associated drive for return on capital, has acted as the catalyst for this behavioural change.

Market access is developing into an important area of focus for the industry, with institutions looking to develop the number of tools in their toolbox to ensure they maximise the routes to market. The market has seen a marked increase in the demand for new clearing and settlement legal solutions with both a rise of pledge structures and central counterparty (CCP) activity globally. It is likely, however, that these solutions while attractive in part, will only ever represent a proportion of overall activity, with classic over-the-counter remaining the majority stakeholder for some time to come.

2017 also saw the introduction of all-to-all trading venues via multilateral trading facility platforms offering to unlock ‘golden sources’ of high-quality assets to the market. While there has been much discussion about the move away from over-the-counter/voice execution towards the new model, we have yet to see significant volume develop. In some ways, it has suffered from some of the same legal and infrastructural challenges that beset CCP development, but, it is one to watch in 2018.

From a collateral perspective, the market continued to see a marked increase in triparty activity and non-cash collateral generally. In the US, it appears that cash collateral was no longer dominant when borrowing equities with non-cash collateral looking to eclipse cash for the first time (nearing 50 percent share, up from 20 percent in 2013). It seems, beneficial owners outside the US are far more able to accept non-cash collateral, and have therefore been the beneficiaries of this shift, however, if the much-anticipated SEC Rule 15c3-3 changes comes into effect in 2018 this could level the playing field and provide a welcomed stimulus to domestic US securities lenders.

Another notable trend of 2017, and one that shows no sign of abating, is the requirement for enterprise-wide and optimised collateral management. This requirement is correlated to the widespread adoption of Basel III regulation by financial service companies and an increasing reliance on SFT trading to achieve adherence. Institutions face increased capital impact as well as top-line cost impacts of expanding secured financing activities and are therefore looking to improve their operating practices. The ideal outcome encompasses all asset classes and margin requirements across an institution and brings with it an increased demand for centralisation, automation & mobility of collateral activities. It seems this is best solved in an iterative manner with an emphasis on connectivity and real-time data in order to provide optimal visibility, interoperability and scope for optimisation across an organisation.

Future’s bright

There has been much debate and discussion in 2017 about impending new technologies, dominated by artificial intelligence, machine learning and distributed ledger technology, it remains to be seen to what extent we will see evolution versus revolution.

In some cases, it seems that proponents are pushing these as solutions that are looking for a problem. In relation to artificial intelligence, it would surprise many to learn how much this already occurs in the securities financing arena, especially in processes such as mark-to-market, returns and collateral management where logic can be learned, evolved and applied. Our view is that no one monolithic solution will be introduced as a panacea to all, rather we are likely to see a more iterative and more piecemeal development in the coming years.

One revolution that is in no doubt occurring in securities financing and more broadly is that of the ‘Network Economy’. An ecosystem is developing that is increasingly digitised, highly interactive, real-time and demands connections among businesses and institutions. Heads of business are increasingly realising that in order to achieve the technological sophistication they require to achieve business targets, they can no longer rely solely on internal builds.

When you consider the multitude of connectivity and input variables required as well as time criticality, increasingly firms are looking for external solutions to help them meet and manage these requirements especially where the solution is non-differentiating. Firms are therefore allocating their internal resources to areas that will provide them proprietary or relative outperformance.

It seems that in 2018 we are likely to see this speed of change continue to accelerate. The encouraging news is that this year should be the first where regulation does not dominate the agenda and businesses can once more focus on shareholder value added. Furthermore, given the industry’s increasing openness to review, change and improve its processes and ecosystem, greater efficiency should be achieved in the operating models with many sub-optimal processes automated.

As a result, while revenues may continue to be challenged, the ability of the industry to improve overall profitability should be very achievable through process efficiencies. That coupled with ongoing positive global market sentiment, suggests that 2018 could well be a memorable year and certainly one to look forward to. So, all that is left for me to do is to wish you a Happy New Year from all at Pirum and look forward to our continued collaboration with you all in 2018.
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