Securities lending in 2016 and beyond
27 September 2016
Lance Wargo of BNP Paribas takes a look the potential opportunities that the next few years may offer to securities lending participants
Image: Shutterstock
The nature of agency lending is changing along with financial markets in the post-global financial crisis era. Agent lenders have become more responsive to their clients, as well as to the needs of their counterparties in the face of complex regulatory requirements. Some institutions view 2016 and beyond as an uncertain time for their securities lending programs, while others have doubled their commitments to the business. At BNP Paribas, we see opportunities on the horizon for our clients and our program, despite unpredictable markets and a heightened regulatory framework
Market dynamics
Asset owners today are confronted with insufficient returns across many capital market activities. The combination of regulation, reduced risk appetite, record low interest rates and lack of program customisation all combine to present a rather challenging future for securities finance. Furthermore, with global interest rates set to remain low, and in some cases negative, for the foreseeable future, investors have to take a fresh look at investment strategies and where value can be extracted on a risk adjusted basis in their securities lending programs. To address the mounting pressure on investment return and principle, asset owners are driven to examine alternative methods and strategies within their investment portfolios to generate intrinsic value and return in areas that may have, up until now, been under-utilised.
Notwithstanding the compelling regulatory and market headwinds investors see today, opportunities to generate securities lending revenue remain robust. Many investors are well positioned to benefit from the variety of different market conditions and trading strategies available in the market today. In particular, opportunities remain abundant as a result of the shift in global growth and commodity demand dynamics, through targeted equity activity focusing on M&A 鈥榮pecials鈥� and the lending of high-quality liquid assets (HQLAs) across fixed income markets.
In search of yield
The search for incremental returns has led beneficial owners to entertain a variety of revenue generation strategies that fit within their risk parameters. As such, demand for a customised, separately managed account tailored to a client鈥檚 risk profile continues to gain traction. Many beneficial owners learned a hard lesson during the financial crisis and realised that 鈥榦ne-size-fits-all鈥� programmes clearly undermine securities lenders鈥� ability to manage risks.
We are experiencing increasing utilisation of tailored securities lending solutions鈥攃ustomisation related to liquidity, reinvestment parameters and asset class expertise are often cited as the rationale for engaging in a third party lending strategy. This is a somewhat different model than 20 years ago and has strong commonalities with portfolio management in that clients tend to take an active approach to program management, including the setting of lending limits and asset class participation. These customised solutions, combined with the transparency they offer, present an effective means for industry participants to capitalise on market opportunities in a risk-controlled manner.
While capital costs remain the primary consideration, the securities lending market has a massive opportunity in the very near future: the rise of US interest rates. This will have a positive impact for beneficial owners, agent lenders, prime brokers and hedge funds alike. The securities lending market has been hampered by an inability to generate revenue from conservative cash investments. Rising rates mean that securities lenders have the opportunity to implement a variety of strategies to reinvest cash and earn a better return than today. At the forefront of these opportunities is engaging in an interest rate mismatch lending and reinvestment strategy. This type of portfolio strategy is very client-specific and not appropriate for all securities lending participants, but is impactful from a revenue generation perspective. While higher interest rates will present some interesting opportunities, it is imperative beneficial owners are comfortable with the adjusted risk return associated with this strategy.
The regulatory environment: headwinds and opportunities
In terms of the amount of regulation that already exists or is due to come into force in the future, it is an unprecedented time for the securities finance markets. At the moment, it may not be possible to accurately judge the extent of these new regulations. Nevertheless, an impact will certainly be felt on demand in the securities lending market. The following key pieces of financial regulation are affecting the securities lending market today and, are expected to continue to affect the market through 2017.
The global regulatory environment on securities lending has affected both the cost of operating a lending programme while creating capacity issues for many lending agents.
The impact of Dodd-Frank Rule 165(e) on US-domiciled institutions has been strenuous. These institutions are facing capacity issues with many of their counterparties as the 15 percent threshold for many US institutions has been inhibiting the ability to maximise the utilisation rates on specific assets classes or, rather, focus solely on lending securities with the highest spread.
Rule 165(e) is one major piece of regulation affected lending programmes causing lower utilisation rates and thus decreased income as lower margin trades are not conducted. Banks with larger capital bases, such as BNP Paribas, will have an advantage over their smaller peers on this front since they have the capacity to support larger credit exposures and, hence, to accommodate higher business volumes.
The Collins Amendment has made it cost-prohibitive for some US domiciled institutions to provide indemnification against counterparty default. Some US agent lenders are limiting the size of their programs to include only the most profitable clients or implementing minimum spread thresholds to cover their capital costs for purposes of indemnification, while others are adjusting their client fee splits much to the detriment of beneficial owners. At BNP Paribas, we have the flexibility to deploy our capital more efficiently under the advanced approach calculation, which is less stringent than the standardised approach in response to this requirement. That said, we are able to lend all assets classes and lend on behalf of clients without implementing minimum spreads or adjusting our fee split.
Increased regulation on banks and balance sheet usage has had a significant impact on borrower motivation across the industry. The most apparent being the condition on banks to ensure their short term funding requirements, under Basel III (liquidity coverage ratio and net stable funding ratio), are managed in line with regulatory imposed leverage ratios.
The impact of these requirements is a dramatic increase in the demand to borrow HQLA (primarily US and European government bonds) on a term basis, generating significant returns over those achieved on an open basis.
Evolving client demands
Due to regulatory and wider market concerns, participants in securities lending programs require a tremendous amount of continuing education while demanding absolute transparency from their lending program providers. BNP Paribas has openly welcomed this transformation and has made these attributes a pillar of its product offering. We provide clients with a top down and bottom up approach to meet their needs with access to senior management throughout the firm. Additionally, BNP Paribas encourages clients to speak directly with its trading desk to discuss market or regulatory matters.
Despite the numerous headwinds surrounding the securities finance industry, opportunities indeed exist for clients willing to explore a few non-traditional strategies within their lending program.
Collateral transformation and cash collateral remain at the forefront of these opportunities along with direct lending, CCPs, and expanding the permissible borrower base. In addition, the ability to articulate the impact of regulatory changes on the securities lending programme of a client is imperative.
We have been early adopters of the approach that clients are entitled to understand the 鈥榳hy鈥� and 鈥榟ow鈥� rather than just the end result. The ability to understand the client and their objectives enables BNP Paribas to design, customise and implement a lending programme suited to each individual client and their goals.
A confident but cautious future
New and enhanced financial regulation has fundamentally changed the securities lending market from one of self-regulation, to one that is centrally regulated through investor guidelines, market directives and direct policy. All participants in securities lending are beneficiaries of these enhanced regulatory policies and directives, and will continue to gain from market transparency and regulatory oversight policies.
Low interest rates and enhanced regulation, however, have greatly reduced certain revenue opportunities previously enjoyed by market participants. But, as new market infrastructure initiatives and enhanced transparency reporting develops鈥攂oth of which BNP Paribas has been vigorously promoting鈥攕ecurities lenders are well-placed to benefit from the many opportunities that this efficient and highly regulated market can offer.
Market dynamics
Asset owners today are confronted with insufficient returns across many capital market activities. The combination of regulation, reduced risk appetite, record low interest rates and lack of program customisation all combine to present a rather challenging future for securities finance. Furthermore, with global interest rates set to remain low, and in some cases negative, for the foreseeable future, investors have to take a fresh look at investment strategies and where value can be extracted on a risk adjusted basis in their securities lending programs. To address the mounting pressure on investment return and principle, asset owners are driven to examine alternative methods and strategies within their investment portfolios to generate intrinsic value and return in areas that may have, up until now, been under-utilised.
Notwithstanding the compelling regulatory and market headwinds investors see today, opportunities to generate securities lending revenue remain robust. Many investors are well positioned to benefit from the variety of different market conditions and trading strategies available in the market today. In particular, opportunities remain abundant as a result of the shift in global growth and commodity demand dynamics, through targeted equity activity focusing on M&A 鈥榮pecials鈥� and the lending of high-quality liquid assets (HQLAs) across fixed income markets.
In search of yield
The search for incremental returns has led beneficial owners to entertain a variety of revenue generation strategies that fit within their risk parameters. As such, demand for a customised, separately managed account tailored to a client鈥檚 risk profile continues to gain traction. Many beneficial owners learned a hard lesson during the financial crisis and realised that 鈥榦ne-size-fits-all鈥� programmes clearly undermine securities lenders鈥� ability to manage risks.
We are experiencing increasing utilisation of tailored securities lending solutions鈥攃ustomisation related to liquidity, reinvestment parameters and asset class expertise are often cited as the rationale for engaging in a third party lending strategy. This is a somewhat different model than 20 years ago and has strong commonalities with portfolio management in that clients tend to take an active approach to program management, including the setting of lending limits and asset class participation. These customised solutions, combined with the transparency they offer, present an effective means for industry participants to capitalise on market opportunities in a risk-controlled manner.
While capital costs remain the primary consideration, the securities lending market has a massive opportunity in the very near future: the rise of US interest rates. This will have a positive impact for beneficial owners, agent lenders, prime brokers and hedge funds alike. The securities lending market has been hampered by an inability to generate revenue from conservative cash investments. Rising rates mean that securities lenders have the opportunity to implement a variety of strategies to reinvest cash and earn a better return than today. At the forefront of these opportunities is engaging in an interest rate mismatch lending and reinvestment strategy. This type of portfolio strategy is very client-specific and not appropriate for all securities lending participants, but is impactful from a revenue generation perspective. While higher interest rates will present some interesting opportunities, it is imperative beneficial owners are comfortable with the adjusted risk return associated with this strategy.
The regulatory environment: headwinds and opportunities
In terms of the amount of regulation that already exists or is due to come into force in the future, it is an unprecedented time for the securities finance markets. At the moment, it may not be possible to accurately judge the extent of these new regulations. Nevertheless, an impact will certainly be felt on demand in the securities lending market. The following key pieces of financial regulation are affecting the securities lending market today and, are expected to continue to affect the market through 2017.
The global regulatory environment on securities lending has affected both the cost of operating a lending programme while creating capacity issues for many lending agents.
The impact of Dodd-Frank Rule 165(e) on US-domiciled institutions has been strenuous. These institutions are facing capacity issues with many of their counterparties as the 15 percent threshold for many US institutions has been inhibiting the ability to maximise the utilisation rates on specific assets classes or, rather, focus solely on lending securities with the highest spread.
Rule 165(e) is one major piece of regulation affected lending programmes causing lower utilisation rates and thus decreased income as lower margin trades are not conducted. Banks with larger capital bases, such as BNP Paribas, will have an advantage over their smaller peers on this front since they have the capacity to support larger credit exposures and, hence, to accommodate higher business volumes.
The Collins Amendment has made it cost-prohibitive for some US domiciled institutions to provide indemnification against counterparty default. Some US agent lenders are limiting the size of their programs to include only the most profitable clients or implementing minimum spread thresholds to cover their capital costs for purposes of indemnification, while others are adjusting their client fee splits much to the detriment of beneficial owners. At BNP Paribas, we have the flexibility to deploy our capital more efficiently under the advanced approach calculation, which is less stringent than the standardised approach in response to this requirement. That said, we are able to lend all assets classes and lend on behalf of clients without implementing minimum spreads or adjusting our fee split.
Increased regulation on banks and balance sheet usage has had a significant impact on borrower motivation across the industry. The most apparent being the condition on banks to ensure their short term funding requirements, under Basel III (liquidity coverage ratio and net stable funding ratio), are managed in line with regulatory imposed leverage ratios.
The impact of these requirements is a dramatic increase in the demand to borrow HQLA (primarily US and European government bonds) on a term basis, generating significant returns over those achieved on an open basis.
Evolving client demands
Due to regulatory and wider market concerns, participants in securities lending programs require a tremendous amount of continuing education while demanding absolute transparency from their lending program providers. BNP Paribas has openly welcomed this transformation and has made these attributes a pillar of its product offering. We provide clients with a top down and bottom up approach to meet their needs with access to senior management throughout the firm. Additionally, BNP Paribas encourages clients to speak directly with its trading desk to discuss market or regulatory matters.
Despite the numerous headwinds surrounding the securities finance industry, opportunities indeed exist for clients willing to explore a few non-traditional strategies within their lending program.
Collateral transformation and cash collateral remain at the forefront of these opportunities along with direct lending, CCPs, and expanding the permissible borrower base. In addition, the ability to articulate the impact of regulatory changes on the securities lending programme of a client is imperative.
We have been early adopters of the approach that clients are entitled to understand the 鈥榳hy鈥� and 鈥榟ow鈥� rather than just the end result. The ability to understand the client and their objectives enables BNP Paribas to design, customise and implement a lending programme suited to each individual client and their goals.
A confident but cautious future
New and enhanced financial regulation has fundamentally changed the securities lending market from one of self-regulation, to one that is centrally regulated through investor guidelines, market directives and direct policy. All participants in securities lending are beneficiaries of these enhanced regulatory policies and directives, and will continue to gain from market transparency and regulatory oversight policies.
Low interest rates and enhanced regulation, however, have greatly reduced certain revenue opportunities previously enjoyed by market participants. But, as new market infrastructure initiatives and enhanced transparency reporting develops鈥攂oth of which BNP Paribas has been vigorously promoting鈥攕ecurities lenders are well-placed to benefit from the many opportunities that this efficient and highly regulated market can offer.
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