How has securities lending fared in Asia over the past few years and will 2014 look much different?
Robert Lees: The last few years have been interesting, and 2011 and 2012 in particular were very good for a couple of reasons. First, we saw an increase in directional lending opportunities in Hong Kong, which was largely driven by investor concerns over slowing growth in China, corporate governance issues in some sectors, and an overarching feeling that the property sector was overvalued. Second, we saw a strong increase in investor asset allocation into Asia, in particular hedge fund growth, which in turn drove demand to borrow securities.
In 2013, however, some of the concerns over China鈥檚 economy eased, as an annualised growth rate of 7.7 percent was achieved and the central government was able to effectively manage that growth. As a result, demand remained relatively strong, but the improved economic conditions combined with global central banks鈥� quantitative easing and a smooth political transition in China, led to a reduction in activity overall and consequently a softening in lending fees.
Fast forward to 2014 and we think things are back on the uptick. Recent data emanating from China has been mixed as the Chinese leadership increasingly focuses on developing a balanced economy that in the future, is driven more by domestic consumption and is less reliant on exports. The slower growth rate expected in the Chinese economy, coupled with the US Federal Reserve tapering its bond purchase programme, gives us reason to be optimistic that securities lending activity will increase in the region, particularly in sectors that are vulnerable to an economic slowdown鈥攆or example, commodities, consumer discretionary products and natural resources.
How is the development of a securities lending framework taking shape in China and do you see the potential for growth?
Zubair Nizami: So far, the China Securities Regulatory Commission (CSRC) has followed a similar path to other countries that have committed to developing a fully functioning securities lending and borrowing (SBL) framework鈥攖hat is, proceeding in a structured manner and at a pace designed to ensure the appropriate checks and balances are considered throughout the entire process. This is consistent with the way the CSRC has approached the development of the entire financial services sector in China.
Given that there has already been a successful Chinese SBL trial between a select group of domestic brokers, we have every reason to believe that in the longer term, the CSRC may introduce a similar trial programme for foreign (QFII) participants. That said, it is difficult to predict with any degree of certainty when such a programme will be introduced. This will largely depend on the priorities of the CSRC and will only be implemented when they have achieved the requisite level of comfort with the domestic SBL programme.
What is the outlook for other emerging markets in the region?
Nizami: Starting with Taiwan, I鈥檇 say demand continues to be strong, but we鈥檝e definitely seen spreads compressing in recent years as the growing number of beneficial owners engaged in lending in Taiwan has resulted in more supply entering the market. That said, it is still an important source of revenue for beneficial owners and considering some of the discussions taking place around further reforms, such as a potential relaxation of the short selling quota and additional forms of collateral being permitted (Euro and yen cash), lending activity could be further stimulated in this market.
Aside from Taiwan, Malaysia is a market that has come into focus more recently, as reforms to the lending model have encouraged more activity from both lenders and borrowers. This is a positive development for the industry and will likely encourage greater participation from end-users like equity long/short funds who rely on increased liquidity to meet their investing needs. This will, in turn, increase overall borrowing demand in the market.
It鈥檚 also interesting to note that the industry is seeing some movement in Indonesia. The Indonesian Clearing & Guarantee Corp (KPEI) and Indonesian Central Securities Depository (KSEI) have been in consultation with the Korean Securities Depository (KSD) to develop an offshore SBL framework. Details haven鈥檛 been released, but the industry expects a bilateral SBL model will be developed sometime in the next few years.
What are your views on how global regulation will impact the industry and what should beneficial owners be aware of?
Lees: There are many rules that could have some form of impact on securities lending. Some are still to be finalised, but it鈥檚 likely that Basel III, Dodd-Frank Section 165(e), the Financial Stability Board鈥檚 shadow banking rules, and the EU Financial Transaction Tax, will have an impact on the profitability of the securities lending business for agent lenders and borrowers, and that will impact how some do business. Certain rules call for an increased draw on capital and credit lines, and for agents that means they may become more focused than ever on ensuring resources are used as efficiently as possible.
As supply chain participants re-evaluate the utilisation of resources to focus on their higher margin businesses, I believe the shift towards intrinsic value lending that we鈥檝e seen over the past few years is here to stay. The impact on individual agent lenders and any subsequent action they take will vary depending on the structure of their programme. But at a broad level, it could result in increased fee splits and a greater focus on more profitable higher margin strategies, as well as changes to how indemnification is currently offered in light of the increased amount of capital it will require.
What impact would changes to indemnification have on beneficial owners?
Lees: We understand that indemnification is an important risk mitigant for some beneficial owners, but it鈥檚 important to put its provision into some perspective. Lending transactions are fully collateralised with a margin that represents a strong risk adjusted return compared with other trades. The provision of an indemnification offers beneficial owners an additional safety net, but it is a guarantee that is not really seen elsewhere in portfolio management.
A key discussion for the industry at the moment centres on whether it is really necessary to provide an indemnification if you have already implemented the right collateral and credit parameters. Ultimately, the overarching concern for beneficial owners should be to ensure that your lending agent follows robust risk and control parameters, is aligned with your individual risk profile and is focused on helping you meet your long-term objectives.
Is there room for central counterparty models in Asia?
Nizami: At the moment, we see little impetus for the industry to move to a central counterparty (CCP) model in Asia. Industry participants on both sides of the lending transaction are comfortable that many of the benefits a CCP is able to offer, are already provided by an agent lender in a bilateral model. Unless CCPs are mandated by regulators in the region or they can offer significant capital savings to counterparties, it is unlikely we will see much traction in the near future.
What are the growth prospects for Asia overall and how is BBH positioning itself for growth here?
Lees: We are more confident than ever about the strength of our position both at an industry level and in Asia. BBH has always been a specialist intrinsic value lender and we have prided ourselves on our expertise in lending emerging market equities, which means our strengths play very well to the opportunities available in Asia. Emerging markets such as Taiwan and Malaysia, and in the longer term Indonesia, continue to be a focus for us and we are excited about the future opportunity of the region as a whole.
In terms of developments on the horizon, the Mutual Recognition scheme between Hong Kong and mainland China is much anticipated and could present the potential for significant growth in the region. In BBH鈥檚 assessment, we think that Hong Kong-China mutual recognition could develop into a $400 billion market in the next five to 10 years. The opportunities may not be immediate, but the size and scale of the scheme could present substantial opportunities in the medium to long-term and is something that BBH continues to monitor closely. This coupled with the growth in domestic Hong Kong funds means that there will certainly be attractive opportunities for managers actively engaged in lending.
Asia will continue to be an exciting part of our product offering and considering the strong fundamentals and optimism in the region, will remain a strategic priority for our programme
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