Building momentum in 2018
23 January 2018
Securities financing experts analyse some of the key issues likely to affect the market in 2018 and what they feel beneficial owners need to focus on
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Are you positive or negative about the prospects of the securities lending market this year?
Peter Bassler: We are optimists. We see a robust pipeline of potential request for proposals, as well as new entrants into the marketplace. Although US equity returns were challenged in 2017, we are hopeful that at some stage, we will see volatility return, which will translate into a broader specials market to drive lending returns. Generally, we want an upward stock market with good volatility, and all we have seen over the last few years is a strong stock market with little volatility.
This is likely to change at some point, and that should bring equity lending returns back up to a normalised level. Additionally, changing market dynamics for collateral is leading to further engagement with clients. We see collateral flexibility as key to optimising returns. Beneficial owners are embracing this and rethinking their parameters and guidelines.
Robert Chiuch: I鈥檓 also positive. Financial firms鈥� balance sheets are in better shape to enable growth of their financing activities. The confluence of a steepening yield curve, the potential for favourable regulatory revisions relating to securities finance, changes in US tax policy that may provoke more corporate action activity and signs of growing strength in global economies, could all generate favourable trade winds. This may promote a return to more conventional markets and a general increase in hedging/shorting activity and other securities finance-related services. The prospect of higher balances due not only to higher valuations but, also, faster growth in volumes, will be a positive thing.
James Gerspach: The continued evolution in the regulatory environment and ongoing market rally presents challenges to securities lending and financing. Market participants are exploring new avenues of distribution, broader collateral types, better technology and multiple other initiatives that are aimed at increased lending activity and efficiencies. These and other efforts should create opportunities for expansion and increased performance as we move through 2018.
Joseph Santoro: We are extremely positive about the prospects for the global securities lending market this year. The steady improvement of the worldwide economies, as well as the low interest rate environment, should have investors looking to the global equities market for better returns. We also expect the worldwide demand for high-quality liquid assets (HQLA) to continue providing a consistent source of revenue for those holders.
The passage of new tax legislation, along with other growth-oriented economic policies in the US is a windfall for corporate earrings driving the business environment and financial markets in a more positive direction. Many US corporate and private equity executives surveyed expect an acceleration of merger and acquisition (M&A) activity in 2018, both in the number of deals and the size of transactions. While uncertainty remains regarding some aspects of Brexit, we may see more M&A activity in the UK and Europe as businesses position themselves for the change. Ideally, we hope this leads to amplified demand for specials, as well as HQLA.
Michael Saunders: At BNP Paribas, we anticipate that a variety of factors, driven by increased market volatility, will result in opportunities for our programme participants in 2018. The normalisation of the Federal Reserve鈥檚 balance sheet, combined with the continued rate tightening cycle, should cause a return to volatility for both the fixed income and equity markets this year. Certainly, geopolitical pressures, which should not be underestimated, will also drive volatility.
Additionally, we believe the themes of pressure on the retail sector due to the 鈥楢mazon effect鈥�, along with weakness in the commodity sector seen last year, will carry over well into 2018.
We also expect the insatiable demand for high-quality liquid assets to remain robust, leading to market opportunities for participants that are willing to engage in collateral transformation transactions.
Finally, with tax reform now completed, record levels of corporate cash will continue to lead to increased merger and acquisition activity, translating into opportunities.
Francesco Squillacioti: I am positive. On the one hand, I feel like, if nothing else, given the dearth of specials last year, something has to give in 2018. That said, my team is finding ways to capitalise on opportunities, even if the dearth continues. I also feel like we have done a great job working with our client base, and their interest level in engaging in or expanding securities lending mandates is quite high.
George Trapp: At Northern Trust, we are positive about the prospects of the securities lending market in 2018. Last year, we continued to generate incremental income for clients despite several headwinds including increased regulation, lower market volatility and rising interest rates. Some of those themes will carry forward to 2018. We will continue discussing the securities lending market with prospects and clients to help ensure their programmes meet their risk and return objectives. We expect that the securities lending market will continue to be favourable to our clients throughout the year.
Matt Wolfe: Positive. We have experienced continued growth over the last several years. In 2017, cleared stock loan volume at OCC was up 22 percent from 2016鈥檚 figure. We expect to see that continue in 2018 as we work to enhance our programme and add participants. Some of the enhancements we are working on include product enhancements as well as expanding OCC鈥檚 membership criteria to support a broader set of lenders.
It seems that the investments made across the industry in order to better understand and manage the capital and balance sheet costs of transactions are showing benefits. It also appears that the industry has adapted to regulatory changes and is now better positioned to understand and identify opportunities. Hopefully that will translate to increased balance sheet allocations and innovative counterparty decisions that will increase both rates and utilisation.
What should be top of the list of concerns for beneficial owners in 2018?
Trapp: We continue to react to changes in borrower demand as a result of the borrowers needs to comply with various regulations. Clients should consider whether to accept a broader range of collateral given the continued demand from borrowers for loans against non-cash collateral. We expect borrowers to put greater emphasis on differentiating client types on certain transactions due to regulatory reasons.
Borrowers have become increasingly focused on the principals they borrow from in securities lending transactions, with a move towards borrowing from the most capital efficient lender types. These include principals with low capital requirements, entities that are optimal counterparties as relates to certain measures like net stable funding ratio (NSFR) and those principals where legal enforceability of netting can be determined. Additionally, borrowers are looking for this information to be available on a pre-trade basis in the future.
Squillacioti: I think a theme this year, and recent years in general, is flexibility. Clearly, non-cash activity has been growing and doesn鈥檛 seem like it will slow. At the same time, rates are rising, creating new opportunities for cash reinvestment. I think beneficial owners should make sure that they are able to take advantage of both.
Chiuch: For beneficial owners participating in securities lending, the first order of business should be to do a careful review of their acceptable collateral profile to ensure optimal participation in light of the entity鈥檚 relevant eligibility prescriptions. Cash will once again come into favour and the ratio of cash to non-cash collateral may need to be reconsidered by borrowers.
The absence of intrinsic specials demand (low VIX readings and gradual rise in rates) will likely compress spreads which could result in higher balances and lower profitability. While compressed spreads will remain a theme for 2018, agile lenders with flexible collateral schedules that appropriately consider cash and non-cash collateral will generally outperform their peers in generating higher total earnings even with, albeit, conservative cash spreads.
Bassler: Collateral guidelines and understanding the new market dynamics as it relates to collateral and borrower preferences is crucial in today鈥檚 market environment. Non-cash in the US market has increased across most lending agents and different borrowers will be looking for greater collateral flexibility as they prioritise who they borrow securities from in this enhanced regulatory environment.
This requires dialogue with your agent to understand risk and return trade-offs and showing collateral flexibility will go a long way towards optimising revenue for investor portfolios. Additionally, for non-cash collateral, understanding the account structure at the triparty agent is also important. A beneficial owner should look for arrangements where they have a segregated account with their specific approved collateral schedule. Commingled accounts for triparty collateral can lead to complications in a market stress situation.
Indemnification also continues to be a hot topic. Many feared that agents would strip them of this protection or raise fees. We have not seen that as overtly over the past few years. However, the large bank agents do have an increased cost due to new regulations, and that means they must adjust trading behaviours to meet profitability hurdles. In cases where they haven鈥檛 taken away the indemnity or charged more in the way of fees, we are seeing some firms change lending patterns or collateral preferences that favour the bank鈥檚 capital treatment. This may or may not be in the client鈥檚 best interests, and we encourage beneficial owners to inquire about how increased indemnity costs will affect their agent and their programme specifically. Just because they continue to indemnify at the same fees doesn鈥檛 mean your programme is unaffected. As an example, if you are a general collateral lender, this may be an area where your agent is cutting back due to indemnity costs.
Turning to new markets, the dividend yield enhancement markets in Europe have seen declining returns for many years. With this as the new norm, Asia has become a larger focus in terms of revenue generation. Markets such as Taiwan and Malaysia can be highly attractive from a revenue perspective so long as you and your agent understand the operational and legal complexities and what is necessary from an infrastructure and risk protection perspective. Additionally, we opened lending in Russia and are increasingly looking at new markets such as India, Indonesia, the Philippines and a few Middle Eastern countries. New markets require attention and understanding and are a strong space to find new areas to extract value. Early entrants who understand the dynamics will benefit before the market becomes mature.
Gerspach: Beneficial owners need to recognise continuations of trends evident in 2017. We expect that borrowers will continue to allocate business based on a number of variables, including availability, counterparty credit, collateral flexibility and cost-minimisation. In 2017, US borrowers moved a significant portion of their US equity short positions to offshore entities, due to stricter capital rules for their US entities. They also continued to expand their use of non-US, non-cash collateral. Both trends are expected to continue in 2018.
Beneficial owners should continue to understand the risk and control framework employed by their lending agents as the market environment continues to evolve. New trades, collateral categories and counterparties will create an increasing necessity for oversight and interaction between lenders and their agents. Lenders should work with their agents to discuss programme structures, markets and trade opportunities to explore the potential financial benefits to them, and what risks exist in them.
Saunders: Market participants should continue to focus on monetising their portfolio of lendable assets. Extracting value from their lending programme will remain difficult for beneficial owners that are reticent about engaging in new, forward-thinking strategies.
One area of focus should be the increased use of technology to maximise the efficiency of their programme. This includes the use of blockchain, as well as the review of traditional operating structures typically associated with securities finance.
Beneficial owners would also be well served to examine the expertise of their agents, focusing on the investment their agent has made in technology, as well as the development of their agent鈥檚 programme offering, including non-cash collateral, exposure to new markets, direct lending and asset class expertise.
Santoro: This year should be a year of agent-client engagement. With many regulatory changes in effect, and some yet to be finalised, beneficial owners in the US and overseas would be well served to engage their agent as to how change affects them, their agent, and counterparties. The new environment presents opportunities for those willing to invest the time in optimising their strategy and using securities lending in new ways.
Deutsche Bank has always put the interests of beneficial owners first, however, we would not be fulfilling our fiduciary role if we failed to communicate the challenges facing counterparties. Trading flexibility, such as collateral types and legal domicile, can provide counterparties with balance sheet relief while rewarding clients with measurable improvements in returns. Similarly, counterparties incur higher balance sheet costs trading with certain client types, so having flexibility in approving borrowers is increasingly important.
Will indemnification continue to be a point of contention for many agent lenders and beneficial owners? Is there a solution?
Bassler: Yes. Although many market practitioners may agree that indemnification may not be needed, if you talk to beneficial owners and their boards, you will quickly learn how important this protection is to retain. Every agent will have a different analysis as it relates to cost and how they run the business in order to meet profitability targets. For eSecLending, we have always had a hard dollar cost for our insurance indemnity. With our indemnity, however, we will not shift borrower preferences or collateral preferences based on new regulations. Our business will always be run with indemnification, and guidelines will revolve around individual client goals and objectives. We will continue to manage individual programmes for each of our clients.
Chiuch: Typically, custody/agent banks are not constrained by capital so incremental indemnified lending activity is not expected to be materially punitive. The impact of indemnification is further lessened through the use of netting agreements that help optimise risk
across counterparties.
It might be useful to consider what drives the need for indemnification: generally, it鈥檚 either a policy matter or a business decision for the beneficial owner. As a business matter, discussions can result in some flexibility and, indemnification could be open for negotiation.
Where indemnification is a policy matter, changes or revisions to a beneficial owner鈥檚 stance, presuming collateral eligibility rules will allow for it, would likely require lengthy debate followed by formal stakeholder approval, usually in the form of board approval. This is a rare event at today鈥檚 marketplace.
Squillacioti: Counterparty default indemnification will continue to be an important part of the comfort level that beneficial owners have when engaging in securities lending. I am not sure that this is contentious for either the beneficial owners or the agent lenders. Both sides, though, do need to work together to make sure that programmes are optimised to take advantage of what is being indemnified.
Santoro: Indeed, indemnification will remain a lively topic. There is no doubt indemnification cost is real. It is factored into relationship pricing. Similarly, as regulatory change has unfolded, beneficial owners have made it clear on panel discussions and via surveys, they consider indemnification essential. Further, nearly all beneficial owners are governed by investment policy or similar constraint, which makes taking on additional risk undesirable or impossible. While agents understand this, it remains to be seen how indemnification cost will play out across beneficial owner relationships. Relationships centered on trading low-demand assets are more likely to be approached about relationship repricing and/or renegotiating the terms of indemnification, if it hasn鈥檛 happened already. Indemnification varies across agents, so it is worth exploring options. We鈥檙e happy to consult with prospective beneficial owners on the finer points of indemnification and relationship pricing.
Saunders: Indemnification will continue to be imperative in lending programmes, as it plays a critical role in satisfying both board mandates and internal guidelines. Several providers continue to have excess capacity to offer indemnification on a variety of asset classes and the challenge for beneficial owners is finding those providers.
Market participants seeking indemnification should engage with providers capable of indemnifying a wide array of collateral, including equities and corporate debt. Beneficial owners willing to examine and understand the financial strength of the indemnifying party will benefit from maximised revenues, as there continues to be a first mover advantage to engaging a provider able to monetise underutilised asset classes.
Wolfe: I think that indemnification will continue to be an important consideration, but I believe that once a CCP solution is available for agent lenders and beneficial owners that indemnification won鈥檛 be as contentious for cleared loans. When beneficial owners and agent lenders are able to clear their transactions, the counterparty becomes a systemically important central counterparty such as OCC with a AA+ S&P rating and a robust and transparent risk management practice. That should significantly reduce the cost and/or capital needed to provide indemnification. Or perhaps someday indemnification will be dropped altogether since the CCP鈥檚 function is to provide a guarantee to the lender against any loss should there be a default by their borrower.
Gerspach: Indemnification plays an important role in the securities lending marketplace as lenders continue to place a high value on this form of risk mitigation offered by lending agents. However, agents and beneficial owners need to have open and frank discussions around what the indemnification actually covers, the costs of this default indemnification and the scope of risks covered in their specific programmes. The factors responsible for revenue generation from lending a portfolio of securities should be as transparent as possible, as should the variables impacting the costs associated with running the programme. Ultimately agents should be sufficiently compensated for running the lending programme, including the provision of risk indemnification.
Trapp: Indemnification will continue to be an important aspect of our client鈥檚 securities lending programmes. Prospect inquiries contain a variety of questions on indemnification proving that it remains an important aspect of the securities lending product. There are differences in the price and types of indemnification offered across the industry regardless of whether it is offered directly from an agent lender or third party.
Prospects and clients are interested in understanding the creditworthiness of the issuer of the indemnification and also the creditworthiness of the agent lender. Financial strength and experience should be the key considerations for beneficial owners as they evaluate an agent lender.
Will the rising interest rates in the US market have a significant effect on collateral in the securities lending market this year?
Chiuch: Given the prospect of accelerating rate hikes鈥攑ossibly four more this year according to research by Capital Economics鈥攅vidence of a steepening curve is mounting. If rates rise too fast and risk-free rates of return begin to look more attractive relative to riskier assets and correlations between asset classes begin to erode, excess cash could find its way into collateral pools at an accelerated rate as markets rebalance and investors ponder their next moves. Assuming rates continue to move higher, I would fully expect cash available as collateral to grow.
The rule of thumb in securities finance for borrowers is to focus on the 鈥榗heapest to deliver鈥� form of collateral. Investors remain significantly long securities, especially with equity markets already up 3-5 percent globally this year. Therefore, non-cash collateral will likely continue to play a key near-term role as investors look to finance their long security positions.
Santoro: As rates rise, agents need to adjust their pricing for accepting various types of collateral relative to what can be earned versus the most conservative overnight investment allowed by the client when accepting cash. While counterparts will continue to optimise their long inventory for balance sheet efficiency, participants in the securities lending market need to remain aware of the ever changing internal cost of financing of different counterparts as well as the expected returns for external financing with cash.
Gerspach: The expectation of a continuation of rate hikes in 2018 will present opportunities for securities lending programmes as fixed income activity increases as a result of interest rate volatility. These opportunities will be seen as potential for increased borrowing of fixed income securities and for increased rates for re-invested securities lending cash collateral.
Saunders: Beneficial owners engaged in cash collateral lending will certainly have opportunities to realise increased revenue opportunities. As the market anticipates several rate increases this year, and as the Libor curve continues to reflect these rates increases, beneficial owners may monetise these opportunities through a variety of portfolio management strategies, specifically an interest rate mismatch strategy.
However, this should be conducted with caution 鈥� it is imperative to ensure ample liquidity exists in your loan portfolio to fund potential forward liabilities. Aside from cash collateral opportunities, rising interest rates will inevitably lead to increased volatility in markets, which will benefit securities finance in general.
Trapp: As a result of changes in the regulatory environment, demand to pledge cash collateral by borrowers in the securities lending market has decreased. Any changes in US short-term rates will have a lower impact than it would have in years past. Last year, reforms in the money markets, not changes in US rates, were the driver of higher cash reinvestment revenue. Looking forward, higher US rates relative to other developing economies may result in higher demand for US Treasuries. Other assets may witness higher demand including specific equity securities or sectors of the market, such as real estate related services if rates continue to rise.
Squillacioti: Yes and no. Yes, in the sense that rising rates clearly will have long-term benefits to securities lenders reinvesting cash collateral, and the additional spread opens various opportunities. No, in the sense that, as I stated earlier, I am not sure that the growth of non-cash will abate any time soon. The key is to be able, wherever possible, to take both kinds of collateral and open further the trading opportunities created.
Last year saw poor equities performance hold back lending revenues. Will 2018 be different?
Santoro: While yield enhancement has continued to wane and specials demand not as strong as previous years, we are confident we have built the ideal platform to harvest whatever returns the market offers. As mentioned earlier, we remain optimistic about 2018 for a number of reasons. Growth oriented economic policies, a strengthening business environment, and a positive outlook on merger and acquisitions (M&A), are all positives. In particular, we will continue to engage with our clients on optimising their strategies against the backdrop of regulatory change. Their ability to be flexible in structuring transactions, accepting different counterparts, and understanding how their flexibility will help propel earnings will be difference makers. Deutsche has built a very successful third-party securities lending franchise that can lend assets anywhere that a client is invested, while interfacing seamlessly with any custodian. In this regard, 2018 will be a very busy year.
Trapp: In 2017, equity markets experienced generally subdued levels of borrower demand as share prices continued to push higher throughout the year and price volatility fell to historic lows. This environment saw many hedge funds adopt a net long exposure, buying equities to take advantage of climbing prices and contribute to performance. As a result, the short side experienced covering and spread compression for much of the year.
Equity market performance in 2018, and consequently the level of price volatility, will depend on a number of factors including progress towards the Trump administration鈥檚 legislative agenda, actions of central banks in the US and abroad and global geopolitical events.
While continued strength in equity prices and lower levels of volatility in 2018 may continue to weigh on borrower demand, we would expect to see continued strong demand for securities in sectors of the economy that may experience elevated levels of price volatility including consumer discretionary, retail, energy and real estate.
Squillacioti: I like to think so, but absent any concrete knowledge, we have been working to be in position to maximise our activity regardless of how the equity market does, and have done a lot of work around collateral and other trade structures at State Street.
Saunders: We anticipate increased volatility across global markets in 2018, which we believe will result in new opportunities for programme participants. While the trends of 2017 will continue well into 2018, inevitably, short interest and volatility are expected to return in the second half of the year. We are examining new lending markets along with strategies to distribute the increasing supply of lendable assets across the globe in an effort to maximise client revenues.
Gerspach: US directional trades drove earnings in 2017, but trades of significance were few in number and concentrated among a few industry sectors.
The US equity rally is expected to continue in 2018, driven in part by tax reform and fewer regulatory burdens. The rally could continue to apply pressure to directional earnings.
Following subdued market volatility in 2017, when US indices typically traded within very narrow bands and the VIX closed at multiple, multi-year lows, analysts are expecting a gradual increase in volatility in 2018 which may add to revenue opportunities. However, lending fees and rebates will remain under pressure due to the abundance of supply relative to demand.
Overall for 2018, we expect to see corporate activity (M&A, capital expenditures, share buybacks and dividends) increase and small- and mid-cap companies outperform, while sectors with a growth bias and low domestic/higher foreign revenue exposure to underperform. We believe that investors are likely to shift from bonds to equities, from international to US equities, and from growth to value.
Bassler: The continued bull market in stocks with low volatility continues to hold back equity lending returns. This won鈥檛 be different until we see things shift, and we are hoping for a higher VIXX in 2018.
Chiuch: 2017 was not a bad year for US equities and there are a number of positive signs pointing to even better performance in 2018. A return to more conventional markets and growing evidence of an improving economy will mean a steeper yield curve and a more traditional inverse relationship between stock and bond prices. Equity lending will continue to benefit from favourable tailwinds of higher valuations in the near term. Equities will naturally be more active especially if rates ultimately rise too quickly and the market rebalances. Fiscal policy measures in the US may also mean increased corporate actions, like M&A for instance, conducive to equity finance. We鈥檙e in an environment where it鈥檚 possible 2018 revenues will grow overall for both equities and fixed income.
Will 2018 be the year CCPs finally get a foothold in the market?
Wolfe: As the only US CCP for securities lending transactions where return of stock or cash to bilateral and exchange-traded securities lending participants is guaranteed, OCC already has a foothold in the securities lending market with over $75 billion in loans being cleared. This year marks 25 years after the launch of our clearing programme, but access has been limited. We are currently working on expanding our model to better accommodate the buy side through various enhancements and are very much looking forward to expanding our footprint and service to the securities lending market.
Saunders: The merits of a CCP are well understood by lending agents and prime brokers. However, a great deal of energy will be spent in 2018 educating beneficial owners about the benefits, risk protections and operating models of lending through a CCP. This will not occur instantaneously and will likely require several quarters, if not longer, of continuous education at the beneficial owner level to understand the economics of participation in a CCP.
Gerspach: Although we believe CCPs will continue to grow and become a larger part of the securities lending market, there are still many open issues that need to be resolved. These will include weighing the risk and reward of signing up a new counterparty, the types of collateral accepted, levels of indemnity and whether the default waterfalls are sufficient. It is possible that CCPs will become an avenue most suited to large sophisticated investors who have the time and resources to ensure that this structure suits their securities lending strategy. Another option is pledge collateral, which achieves many of the capital benefits as CCPs and seems to be gaining importance from the borrowers.
Chiuch: The general answer is yes, but with qualifications. There does not appear to be a one-size-fits-all solution at the moment. What we鈥檒l likely see in the near term is a multi-dimensional marketplace with various solutions available according to specific needs. Not all CCPs are created equal. Some are well along the development curve while others are still trying to define their model. For instance, a well-known US provider is already functional and active in the fixed income space, while another non-US CCP is finalising arrangements in hope of launching this year. Others still appear to have plenty of development work remaining. CCPs are not a panacea that everyone will embrace. While many market participants are keen on CCPs, others are working towards a pledge mechanism while others, still, are content to wait and see how things unfold.
Trapp: While progress continues to be made on CCPs as a potential solution to borrower capital constraints, development has been slow and pledge structures seem to supplant the need for CCPs as a solution. However, CCPs continue to be a major topic of conversation despite the slow progress. An increased number of market participants see CCPs for securities lending as a route to relief from punitive regulatory capital regimes.
The biggest challenge and contributor to the slow speed of a CCP development is the objective of preserving the current securities lending business model to minimise the impact on the various participants. For example, in a typical CCP framework, both parties to a transaction cleared through a CCP would be required to provide margin, contribute to a loss fund, and be subject to broader CCP risk sharing. These requirements do not fit well with the current roles of the client (or agent lender on their behalf) on a securities lending transaction. Therefore, prospective CCP providers are making significant adaptations to their typical CCP framework.
Santoro: A foothold? I鈥檓 afraid not in 2018, but hopefully there continues to be dialogue among agents, CCPs, and clients to establish an acceptable mechanism that is usable for the broader industry. We would expect a few participants in the industry to transact in a CCP in 2018 on a limited basis. Our product development team has been hard at work and Deutsche Bank fully expects to print in a CCP during 2018. That being said, our expectation that the relative volume in 2018 for CCPs will be de minimis.
Squillacioti: CCPs have been discussed for some time now, though there now appears to be growing momentum behind the discussions. There is also a good amount of activity taking place, which leads me to believe that if CCPs do not see a rollout in 2018, they are likely to in 2019. I would caveat this by saying that there is a lot of work to do here. From the models I鈥檝e seen, this represents some significant changes to the traditional agency lending construct. While not insurmountable, the lending agents, borrowers, CCPs will need to come together on a workable model that will cover the greatest possible swathe of activity.
Is the US market likely to see any major reforms to regulation affecting securities financing this year?
Gerspach: Although we don鈥檛 anticipate any major new regulatory reforms coming, those already in place will continue to have an impact on the securities lending and financing market. Agent lenders are in the midst of the rollout of the second Markets in Financial Instruments Directive and many US-based lenders will feel its impact. Agents will also be working with their US mutual fund clients on the continuing requirements of the US Securities and Exchange Commission鈥檚 (SEC鈥檚) Mutual Fund Modernisation Act as it continues on the implementation track.
Saunders: The general consensus among beneficial owners, and even lending agents, when discussing regulatory change is one of acceptance. Agents, prime brokers and beneficial owners have, for the most part, become adjusted to the impact of US regulation in conducting and operating their lending and borrowing business.
Certainly, we have our eye on several critical proposals which would impact the industry, such as the expansion of rule SEC 15c3-3. But until these changes are integrated, we will continue to focus on maximising revenue for our clients and monetising programme participants鈥� underutilised assets with a focus on risk adjusted return.
Finally, our prudent framework is set for 2018, including the ability to serve clients reporting capabilities, such as updates coming via the likes of the Investment Company Reporting Modernisation initiative set forth by the SEC. Maintaining client and regulatory compliance is a key focus of our programme in 2018 and beyond.
Chiuch: We expect that there will be changes to current regulations in 2018 that will reflect the administration鈥檚 principles and implement some of the suggested changes identified in the recent Treasury reports.
These could include changes to the capital rules that may introduce a new standardised calculation methodology for credit exposure for securities lending transactions which was recently finalised by the Basel Committee which would more accurately reflect the actual credit exposure in securities lending transactions. We may also see a new single counterparty credit limit (SCCL) proposal that incorporates the above-referenced calculation methodology as recommended in the recent Treasury Report. Additionally, changes to the leverage ratio (SLR) could result in a recalibration of the enhanced ratio requirement based on the institution and/or exclusion of central bank deposits which may create more capacity and would be favorable for the market.
Trapp: Basel III rules establish the framework for agent lenders to calculate capital requirements to be put aside as a result of providing indemnification to clients. In December of 2017, the Basel Committee issued final revisions to Basel III, which included a more favourable exposure measurement for securities lending transactions and more balanced methodologies to calculate regulatory capital for banks and broker dealers under the Standardised Approach. A US proposal addressing the Basel revisions to the Standardised Approach would be a key development for the industry.
SCCL and NSFR are two important regulations that are yet to be finalised in the US. Similar to the Basel revisions to the Standardised Approach, adjustments to the exposure measure for securities lending transactions in the final SCCL rules would be a key development, particularly for agent lenders. The outcome for the NSFR rules could be meaningful for certain borrowers.
Specific to the EU, SFTR has received a significant amount of the industry鈥檚 attention given the breadth of the requirements and the scope of impact. Although the SFTR reporting regulation is specific to Europe, it will impact various securities lending participants in the US as well. The industry continues to make strides towards meeting the requirements, and vendors are engaged to facilitate collection and aggregation of the data elements required to be reported to the regulators.
Santoro: The current administration has been very clear on their stance regarding major regulatory reforms, and while we do not expect anything dramatically new, we do expect some long-pending regulations to crystalise. Conclusions to single counterparty credit limits, equities as an acceptable form of collateral for equity loans in the US combined with Bank Recovery and Resolution Directive and progress pertaining to Securities Financing Transactions Regulation in Europe will be welcomed by the industry in 2018.
Wolfe: The regulatory changes implemented over the last few years have resulted in a more resilient financial services industry. I haven鈥檛 heard of any major reforms that are in the works. And I would not be surprised to see an initiative in the US similar to SFTR in order to better equip regulators with data to enable them to monitor and fine-tune requirements. My hope for 2018 is to enable more of the market to realise the capital efficiencies and costs savings that are afforded to clearing within the current regulations.
Peter Bassler: We are optimists. We see a robust pipeline of potential request for proposals, as well as new entrants into the marketplace. Although US equity returns were challenged in 2017, we are hopeful that at some stage, we will see volatility return, which will translate into a broader specials market to drive lending returns. Generally, we want an upward stock market with good volatility, and all we have seen over the last few years is a strong stock market with little volatility.
This is likely to change at some point, and that should bring equity lending returns back up to a normalised level. Additionally, changing market dynamics for collateral is leading to further engagement with clients. We see collateral flexibility as key to optimising returns. Beneficial owners are embracing this and rethinking their parameters and guidelines.
Robert Chiuch: I鈥檓 also positive. Financial firms鈥� balance sheets are in better shape to enable growth of their financing activities. The confluence of a steepening yield curve, the potential for favourable regulatory revisions relating to securities finance, changes in US tax policy that may provoke more corporate action activity and signs of growing strength in global economies, could all generate favourable trade winds. This may promote a return to more conventional markets and a general increase in hedging/shorting activity and other securities finance-related services. The prospect of higher balances due not only to higher valuations but, also, faster growth in volumes, will be a positive thing.
James Gerspach: The continued evolution in the regulatory environment and ongoing market rally presents challenges to securities lending and financing. Market participants are exploring new avenues of distribution, broader collateral types, better technology and multiple other initiatives that are aimed at increased lending activity and efficiencies. These and other efforts should create opportunities for expansion and increased performance as we move through 2018.
Joseph Santoro: We are extremely positive about the prospects for the global securities lending market this year. The steady improvement of the worldwide economies, as well as the low interest rate environment, should have investors looking to the global equities market for better returns. We also expect the worldwide demand for high-quality liquid assets (HQLA) to continue providing a consistent source of revenue for those holders.
The passage of new tax legislation, along with other growth-oriented economic policies in the US is a windfall for corporate earrings driving the business environment and financial markets in a more positive direction. Many US corporate and private equity executives surveyed expect an acceleration of merger and acquisition (M&A) activity in 2018, both in the number of deals and the size of transactions. While uncertainty remains regarding some aspects of Brexit, we may see more M&A activity in the UK and Europe as businesses position themselves for the change. Ideally, we hope this leads to amplified demand for specials, as well as HQLA.
Michael Saunders: At BNP Paribas, we anticipate that a variety of factors, driven by increased market volatility, will result in opportunities for our programme participants in 2018. The normalisation of the Federal Reserve鈥檚 balance sheet, combined with the continued rate tightening cycle, should cause a return to volatility for both the fixed income and equity markets this year. Certainly, geopolitical pressures, which should not be underestimated, will also drive volatility.
Additionally, we believe the themes of pressure on the retail sector due to the 鈥楢mazon effect鈥�, along with weakness in the commodity sector seen last year, will carry over well into 2018.
We also expect the insatiable demand for high-quality liquid assets to remain robust, leading to market opportunities for participants that are willing to engage in collateral transformation transactions.
Finally, with tax reform now completed, record levels of corporate cash will continue to lead to increased merger and acquisition activity, translating into opportunities.
Francesco Squillacioti: I am positive. On the one hand, I feel like, if nothing else, given the dearth of specials last year, something has to give in 2018. That said, my team is finding ways to capitalise on opportunities, even if the dearth continues. I also feel like we have done a great job working with our client base, and their interest level in engaging in or expanding securities lending mandates is quite high.
George Trapp: At Northern Trust, we are positive about the prospects of the securities lending market in 2018. Last year, we continued to generate incremental income for clients despite several headwinds including increased regulation, lower market volatility and rising interest rates. Some of those themes will carry forward to 2018. We will continue discussing the securities lending market with prospects and clients to help ensure their programmes meet their risk and return objectives. We expect that the securities lending market will continue to be favourable to our clients throughout the year.
Matt Wolfe: Positive. We have experienced continued growth over the last several years. In 2017, cleared stock loan volume at OCC was up 22 percent from 2016鈥檚 figure. We expect to see that continue in 2018 as we work to enhance our programme and add participants. Some of the enhancements we are working on include product enhancements as well as expanding OCC鈥檚 membership criteria to support a broader set of lenders.
It seems that the investments made across the industry in order to better understand and manage the capital and balance sheet costs of transactions are showing benefits. It also appears that the industry has adapted to regulatory changes and is now better positioned to understand and identify opportunities. Hopefully that will translate to increased balance sheet allocations and innovative counterparty decisions that will increase both rates and utilisation.
What should be top of the list of concerns for beneficial owners in 2018?
Trapp: We continue to react to changes in borrower demand as a result of the borrowers needs to comply with various regulations. Clients should consider whether to accept a broader range of collateral given the continued demand from borrowers for loans against non-cash collateral. We expect borrowers to put greater emphasis on differentiating client types on certain transactions due to regulatory reasons.
Borrowers have become increasingly focused on the principals they borrow from in securities lending transactions, with a move towards borrowing from the most capital efficient lender types. These include principals with low capital requirements, entities that are optimal counterparties as relates to certain measures like net stable funding ratio (NSFR) and those principals where legal enforceability of netting can be determined. Additionally, borrowers are looking for this information to be available on a pre-trade basis in the future.
Squillacioti: I think a theme this year, and recent years in general, is flexibility. Clearly, non-cash activity has been growing and doesn鈥檛 seem like it will slow. At the same time, rates are rising, creating new opportunities for cash reinvestment. I think beneficial owners should make sure that they are able to take advantage of both.
Chiuch: For beneficial owners participating in securities lending, the first order of business should be to do a careful review of their acceptable collateral profile to ensure optimal participation in light of the entity鈥檚 relevant eligibility prescriptions. Cash will once again come into favour and the ratio of cash to non-cash collateral may need to be reconsidered by borrowers.
The absence of intrinsic specials demand (low VIX readings and gradual rise in rates) will likely compress spreads which could result in higher balances and lower profitability. While compressed spreads will remain a theme for 2018, agile lenders with flexible collateral schedules that appropriately consider cash and non-cash collateral will generally outperform their peers in generating higher total earnings even with, albeit, conservative cash spreads.
Bassler: Collateral guidelines and understanding the new market dynamics as it relates to collateral and borrower preferences is crucial in today鈥檚 market environment. Non-cash in the US market has increased across most lending agents and different borrowers will be looking for greater collateral flexibility as they prioritise who they borrow securities from in this enhanced regulatory environment.
This requires dialogue with your agent to understand risk and return trade-offs and showing collateral flexibility will go a long way towards optimising revenue for investor portfolios. Additionally, for non-cash collateral, understanding the account structure at the triparty agent is also important. A beneficial owner should look for arrangements where they have a segregated account with their specific approved collateral schedule. Commingled accounts for triparty collateral can lead to complications in a market stress situation.
Indemnification also continues to be a hot topic. Many feared that agents would strip them of this protection or raise fees. We have not seen that as overtly over the past few years. However, the large bank agents do have an increased cost due to new regulations, and that means they must adjust trading behaviours to meet profitability hurdles. In cases where they haven鈥檛 taken away the indemnity or charged more in the way of fees, we are seeing some firms change lending patterns or collateral preferences that favour the bank鈥檚 capital treatment. This may or may not be in the client鈥檚 best interests, and we encourage beneficial owners to inquire about how increased indemnity costs will affect their agent and their programme specifically. Just because they continue to indemnify at the same fees doesn鈥檛 mean your programme is unaffected. As an example, if you are a general collateral lender, this may be an area where your agent is cutting back due to indemnity costs.
Turning to new markets, the dividend yield enhancement markets in Europe have seen declining returns for many years. With this as the new norm, Asia has become a larger focus in terms of revenue generation. Markets such as Taiwan and Malaysia can be highly attractive from a revenue perspective so long as you and your agent understand the operational and legal complexities and what is necessary from an infrastructure and risk protection perspective. Additionally, we opened lending in Russia and are increasingly looking at new markets such as India, Indonesia, the Philippines and a few Middle Eastern countries. New markets require attention and understanding and are a strong space to find new areas to extract value. Early entrants who understand the dynamics will benefit before the market becomes mature.
Gerspach: Beneficial owners need to recognise continuations of trends evident in 2017. We expect that borrowers will continue to allocate business based on a number of variables, including availability, counterparty credit, collateral flexibility and cost-minimisation. In 2017, US borrowers moved a significant portion of their US equity short positions to offshore entities, due to stricter capital rules for their US entities. They also continued to expand their use of non-US, non-cash collateral. Both trends are expected to continue in 2018.
Beneficial owners should continue to understand the risk and control framework employed by their lending agents as the market environment continues to evolve. New trades, collateral categories and counterparties will create an increasing necessity for oversight and interaction between lenders and their agents. Lenders should work with their agents to discuss programme structures, markets and trade opportunities to explore the potential financial benefits to them, and what risks exist in them.
Saunders: Market participants should continue to focus on monetising their portfolio of lendable assets. Extracting value from their lending programme will remain difficult for beneficial owners that are reticent about engaging in new, forward-thinking strategies.
One area of focus should be the increased use of technology to maximise the efficiency of their programme. This includes the use of blockchain, as well as the review of traditional operating structures typically associated with securities finance.
Beneficial owners would also be well served to examine the expertise of their agents, focusing on the investment their agent has made in technology, as well as the development of their agent鈥檚 programme offering, including non-cash collateral, exposure to new markets, direct lending and asset class expertise.
Santoro: This year should be a year of agent-client engagement. With many regulatory changes in effect, and some yet to be finalised, beneficial owners in the US and overseas would be well served to engage their agent as to how change affects them, their agent, and counterparties. The new environment presents opportunities for those willing to invest the time in optimising their strategy and using securities lending in new ways.
Deutsche Bank has always put the interests of beneficial owners first, however, we would not be fulfilling our fiduciary role if we failed to communicate the challenges facing counterparties. Trading flexibility, such as collateral types and legal domicile, can provide counterparties with balance sheet relief while rewarding clients with measurable improvements in returns. Similarly, counterparties incur higher balance sheet costs trading with certain client types, so having flexibility in approving borrowers is increasingly important.
Will indemnification continue to be a point of contention for many agent lenders and beneficial owners? Is there a solution?
Bassler: Yes. Although many market practitioners may agree that indemnification may not be needed, if you talk to beneficial owners and their boards, you will quickly learn how important this protection is to retain. Every agent will have a different analysis as it relates to cost and how they run the business in order to meet profitability targets. For eSecLending, we have always had a hard dollar cost for our insurance indemnity. With our indemnity, however, we will not shift borrower preferences or collateral preferences based on new regulations. Our business will always be run with indemnification, and guidelines will revolve around individual client goals and objectives. We will continue to manage individual programmes for each of our clients.
Chiuch: Typically, custody/agent banks are not constrained by capital so incremental indemnified lending activity is not expected to be materially punitive. The impact of indemnification is further lessened through the use of netting agreements that help optimise risk
across counterparties.
It might be useful to consider what drives the need for indemnification: generally, it鈥檚 either a policy matter or a business decision for the beneficial owner. As a business matter, discussions can result in some flexibility and, indemnification could be open for negotiation.
Where indemnification is a policy matter, changes or revisions to a beneficial owner鈥檚 stance, presuming collateral eligibility rules will allow for it, would likely require lengthy debate followed by formal stakeholder approval, usually in the form of board approval. This is a rare event at today鈥檚 marketplace.
Squillacioti: Counterparty default indemnification will continue to be an important part of the comfort level that beneficial owners have when engaging in securities lending. I am not sure that this is contentious for either the beneficial owners or the agent lenders. Both sides, though, do need to work together to make sure that programmes are optimised to take advantage of what is being indemnified.
Santoro: Indeed, indemnification will remain a lively topic. There is no doubt indemnification cost is real. It is factored into relationship pricing. Similarly, as regulatory change has unfolded, beneficial owners have made it clear on panel discussions and via surveys, they consider indemnification essential. Further, nearly all beneficial owners are governed by investment policy or similar constraint, which makes taking on additional risk undesirable or impossible. While agents understand this, it remains to be seen how indemnification cost will play out across beneficial owner relationships. Relationships centered on trading low-demand assets are more likely to be approached about relationship repricing and/or renegotiating the terms of indemnification, if it hasn鈥檛 happened already. Indemnification varies across agents, so it is worth exploring options. We鈥檙e happy to consult with prospective beneficial owners on the finer points of indemnification and relationship pricing.
Saunders: Indemnification will continue to be imperative in lending programmes, as it plays a critical role in satisfying both board mandates and internal guidelines. Several providers continue to have excess capacity to offer indemnification on a variety of asset classes and the challenge for beneficial owners is finding those providers.
Market participants seeking indemnification should engage with providers capable of indemnifying a wide array of collateral, including equities and corporate debt. Beneficial owners willing to examine and understand the financial strength of the indemnifying party will benefit from maximised revenues, as there continues to be a first mover advantage to engaging a provider able to monetise underutilised asset classes.
Wolfe: I think that indemnification will continue to be an important consideration, but I believe that once a CCP solution is available for agent lenders and beneficial owners that indemnification won鈥檛 be as contentious for cleared loans. When beneficial owners and agent lenders are able to clear their transactions, the counterparty becomes a systemically important central counterparty such as OCC with a AA+ S&P rating and a robust and transparent risk management practice. That should significantly reduce the cost and/or capital needed to provide indemnification. Or perhaps someday indemnification will be dropped altogether since the CCP鈥檚 function is to provide a guarantee to the lender against any loss should there be a default by their borrower.
Gerspach: Indemnification plays an important role in the securities lending marketplace as lenders continue to place a high value on this form of risk mitigation offered by lending agents. However, agents and beneficial owners need to have open and frank discussions around what the indemnification actually covers, the costs of this default indemnification and the scope of risks covered in their specific programmes. The factors responsible for revenue generation from lending a portfolio of securities should be as transparent as possible, as should the variables impacting the costs associated with running the programme. Ultimately agents should be sufficiently compensated for running the lending programme, including the provision of risk indemnification.
Trapp: Indemnification will continue to be an important aspect of our client鈥檚 securities lending programmes. Prospect inquiries contain a variety of questions on indemnification proving that it remains an important aspect of the securities lending product. There are differences in the price and types of indemnification offered across the industry regardless of whether it is offered directly from an agent lender or third party.
Prospects and clients are interested in understanding the creditworthiness of the issuer of the indemnification and also the creditworthiness of the agent lender. Financial strength and experience should be the key considerations for beneficial owners as they evaluate an agent lender.
Will the rising interest rates in the US market have a significant effect on collateral in the securities lending market this year?
Chiuch: Given the prospect of accelerating rate hikes鈥攑ossibly four more this year according to research by Capital Economics鈥攅vidence of a steepening curve is mounting. If rates rise too fast and risk-free rates of return begin to look more attractive relative to riskier assets and correlations between asset classes begin to erode, excess cash could find its way into collateral pools at an accelerated rate as markets rebalance and investors ponder their next moves. Assuming rates continue to move higher, I would fully expect cash available as collateral to grow.
The rule of thumb in securities finance for borrowers is to focus on the 鈥榗heapest to deliver鈥� form of collateral. Investors remain significantly long securities, especially with equity markets already up 3-5 percent globally this year. Therefore, non-cash collateral will likely continue to play a key near-term role as investors look to finance their long security positions.
Santoro: As rates rise, agents need to adjust their pricing for accepting various types of collateral relative to what can be earned versus the most conservative overnight investment allowed by the client when accepting cash. While counterparts will continue to optimise their long inventory for balance sheet efficiency, participants in the securities lending market need to remain aware of the ever changing internal cost of financing of different counterparts as well as the expected returns for external financing with cash.
Gerspach: The expectation of a continuation of rate hikes in 2018 will present opportunities for securities lending programmes as fixed income activity increases as a result of interest rate volatility. These opportunities will be seen as potential for increased borrowing of fixed income securities and for increased rates for re-invested securities lending cash collateral.
Saunders: Beneficial owners engaged in cash collateral lending will certainly have opportunities to realise increased revenue opportunities. As the market anticipates several rate increases this year, and as the Libor curve continues to reflect these rates increases, beneficial owners may monetise these opportunities through a variety of portfolio management strategies, specifically an interest rate mismatch strategy.
However, this should be conducted with caution 鈥� it is imperative to ensure ample liquidity exists in your loan portfolio to fund potential forward liabilities. Aside from cash collateral opportunities, rising interest rates will inevitably lead to increased volatility in markets, which will benefit securities finance in general.
Trapp: As a result of changes in the regulatory environment, demand to pledge cash collateral by borrowers in the securities lending market has decreased. Any changes in US short-term rates will have a lower impact than it would have in years past. Last year, reforms in the money markets, not changes in US rates, were the driver of higher cash reinvestment revenue. Looking forward, higher US rates relative to other developing economies may result in higher demand for US Treasuries. Other assets may witness higher demand including specific equity securities or sectors of the market, such as real estate related services if rates continue to rise.
Squillacioti: Yes and no. Yes, in the sense that rising rates clearly will have long-term benefits to securities lenders reinvesting cash collateral, and the additional spread opens various opportunities. No, in the sense that, as I stated earlier, I am not sure that the growth of non-cash will abate any time soon. The key is to be able, wherever possible, to take both kinds of collateral and open further the trading opportunities created.
Last year saw poor equities performance hold back lending revenues. Will 2018 be different?
Santoro: While yield enhancement has continued to wane and specials demand not as strong as previous years, we are confident we have built the ideal platform to harvest whatever returns the market offers. As mentioned earlier, we remain optimistic about 2018 for a number of reasons. Growth oriented economic policies, a strengthening business environment, and a positive outlook on merger and acquisitions (M&A), are all positives. In particular, we will continue to engage with our clients on optimising their strategies against the backdrop of regulatory change. Their ability to be flexible in structuring transactions, accepting different counterparts, and understanding how their flexibility will help propel earnings will be difference makers. Deutsche has built a very successful third-party securities lending franchise that can lend assets anywhere that a client is invested, while interfacing seamlessly with any custodian. In this regard, 2018 will be a very busy year.
Trapp: In 2017, equity markets experienced generally subdued levels of borrower demand as share prices continued to push higher throughout the year and price volatility fell to historic lows. This environment saw many hedge funds adopt a net long exposure, buying equities to take advantage of climbing prices and contribute to performance. As a result, the short side experienced covering and spread compression for much of the year.
Equity market performance in 2018, and consequently the level of price volatility, will depend on a number of factors including progress towards the Trump administration鈥檚 legislative agenda, actions of central banks in the US and abroad and global geopolitical events.
While continued strength in equity prices and lower levels of volatility in 2018 may continue to weigh on borrower demand, we would expect to see continued strong demand for securities in sectors of the economy that may experience elevated levels of price volatility including consumer discretionary, retail, energy and real estate.
Squillacioti: I like to think so, but absent any concrete knowledge, we have been working to be in position to maximise our activity regardless of how the equity market does, and have done a lot of work around collateral and other trade structures at State Street.
Saunders: We anticipate increased volatility across global markets in 2018, which we believe will result in new opportunities for programme participants. While the trends of 2017 will continue well into 2018, inevitably, short interest and volatility are expected to return in the second half of the year. We are examining new lending markets along with strategies to distribute the increasing supply of lendable assets across the globe in an effort to maximise client revenues.
Gerspach: US directional trades drove earnings in 2017, but trades of significance were few in number and concentrated among a few industry sectors.
The US equity rally is expected to continue in 2018, driven in part by tax reform and fewer regulatory burdens. The rally could continue to apply pressure to directional earnings.
Following subdued market volatility in 2017, when US indices typically traded within very narrow bands and the VIX closed at multiple, multi-year lows, analysts are expecting a gradual increase in volatility in 2018 which may add to revenue opportunities. However, lending fees and rebates will remain under pressure due to the abundance of supply relative to demand.
Overall for 2018, we expect to see corporate activity (M&A, capital expenditures, share buybacks and dividends) increase and small- and mid-cap companies outperform, while sectors with a growth bias and low domestic/higher foreign revenue exposure to underperform. We believe that investors are likely to shift from bonds to equities, from international to US equities, and from growth to value.
Bassler: The continued bull market in stocks with low volatility continues to hold back equity lending returns. This won鈥檛 be different until we see things shift, and we are hoping for a higher VIXX in 2018.
Chiuch: 2017 was not a bad year for US equities and there are a number of positive signs pointing to even better performance in 2018. A return to more conventional markets and growing evidence of an improving economy will mean a steeper yield curve and a more traditional inverse relationship between stock and bond prices. Equity lending will continue to benefit from favourable tailwinds of higher valuations in the near term. Equities will naturally be more active especially if rates ultimately rise too quickly and the market rebalances. Fiscal policy measures in the US may also mean increased corporate actions, like M&A for instance, conducive to equity finance. We鈥檙e in an environment where it鈥檚 possible 2018 revenues will grow overall for both equities and fixed income.
Will 2018 be the year CCPs finally get a foothold in the market?
Wolfe: As the only US CCP for securities lending transactions where return of stock or cash to bilateral and exchange-traded securities lending participants is guaranteed, OCC already has a foothold in the securities lending market with over $75 billion in loans being cleared. This year marks 25 years after the launch of our clearing programme, but access has been limited. We are currently working on expanding our model to better accommodate the buy side through various enhancements and are very much looking forward to expanding our footprint and service to the securities lending market.
Saunders: The merits of a CCP are well understood by lending agents and prime brokers. However, a great deal of energy will be spent in 2018 educating beneficial owners about the benefits, risk protections and operating models of lending through a CCP. This will not occur instantaneously and will likely require several quarters, if not longer, of continuous education at the beneficial owner level to understand the economics of participation in a CCP.
Gerspach: Although we believe CCPs will continue to grow and become a larger part of the securities lending market, there are still many open issues that need to be resolved. These will include weighing the risk and reward of signing up a new counterparty, the types of collateral accepted, levels of indemnity and whether the default waterfalls are sufficient. It is possible that CCPs will become an avenue most suited to large sophisticated investors who have the time and resources to ensure that this structure suits their securities lending strategy. Another option is pledge collateral, which achieves many of the capital benefits as CCPs and seems to be gaining importance from the borrowers.
Chiuch: The general answer is yes, but with qualifications. There does not appear to be a one-size-fits-all solution at the moment. What we鈥檒l likely see in the near term is a multi-dimensional marketplace with various solutions available according to specific needs. Not all CCPs are created equal. Some are well along the development curve while others are still trying to define their model. For instance, a well-known US provider is already functional and active in the fixed income space, while another non-US CCP is finalising arrangements in hope of launching this year. Others still appear to have plenty of development work remaining. CCPs are not a panacea that everyone will embrace. While many market participants are keen on CCPs, others are working towards a pledge mechanism while others, still, are content to wait and see how things unfold.
Trapp: While progress continues to be made on CCPs as a potential solution to borrower capital constraints, development has been slow and pledge structures seem to supplant the need for CCPs as a solution. However, CCPs continue to be a major topic of conversation despite the slow progress. An increased number of market participants see CCPs for securities lending as a route to relief from punitive regulatory capital regimes.
The biggest challenge and contributor to the slow speed of a CCP development is the objective of preserving the current securities lending business model to minimise the impact on the various participants. For example, in a typical CCP framework, both parties to a transaction cleared through a CCP would be required to provide margin, contribute to a loss fund, and be subject to broader CCP risk sharing. These requirements do not fit well with the current roles of the client (or agent lender on their behalf) on a securities lending transaction. Therefore, prospective CCP providers are making significant adaptations to their typical CCP framework.
Santoro: A foothold? I鈥檓 afraid not in 2018, but hopefully there continues to be dialogue among agents, CCPs, and clients to establish an acceptable mechanism that is usable for the broader industry. We would expect a few participants in the industry to transact in a CCP in 2018 on a limited basis. Our product development team has been hard at work and Deutsche Bank fully expects to print in a CCP during 2018. That being said, our expectation that the relative volume in 2018 for CCPs will be de minimis.
Squillacioti: CCPs have been discussed for some time now, though there now appears to be growing momentum behind the discussions. There is also a good amount of activity taking place, which leads me to believe that if CCPs do not see a rollout in 2018, they are likely to in 2019. I would caveat this by saying that there is a lot of work to do here. From the models I鈥檝e seen, this represents some significant changes to the traditional agency lending construct. While not insurmountable, the lending agents, borrowers, CCPs will need to come together on a workable model that will cover the greatest possible swathe of activity.
Is the US market likely to see any major reforms to regulation affecting securities financing this year?
Gerspach: Although we don鈥檛 anticipate any major new regulatory reforms coming, those already in place will continue to have an impact on the securities lending and financing market. Agent lenders are in the midst of the rollout of the second Markets in Financial Instruments Directive and many US-based lenders will feel its impact. Agents will also be working with their US mutual fund clients on the continuing requirements of the US Securities and Exchange Commission鈥檚 (SEC鈥檚) Mutual Fund Modernisation Act as it continues on the implementation track.
Saunders: The general consensus among beneficial owners, and even lending agents, when discussing regulatory change is one of acceptance. Agents, prime brokers and beneficial owners have, for the most part, become adjusted to the impact of US regulation in conducting and operating their lending and borrowing business.
Certainly, we have our eye on several critical proposals which would impact the industry, such as the expansion of rule SEC 15c3-3. But until these changes are integrated, we will continue to focus on maximising revenue for our clients and monetising programme participants鈥� underutilised assets with a focus on risk adjusted return.
Finally, our prudent framework is set for 2018, including the ability to serve clients reporting capabilities, such as updates coming via the likes of the Investment Company Reporting Modernisation initiative set forth by the SEC. Maintaining client and regulatory compliance is a key focus of our programme in 2018 and beyond.
Chiuch: We expect that there will be changes to current regulations in 2018 that will reflect the administration鈥檚 principles and implement some of the suggested changes identified in the recent Treasury reports.
These could include changes to the capital rules that may introduce a new standardised calculation methodology for credit exposure for securities lending transactions which was recently finalised by the Basel Committee which would more accurately reflect the actual credit exposure in securities lending transactions. We may also see a new single counterparty credit limit (SCCL) proposal that incorporates the above-referenced calculation methodology as recommended in the recent Treasury Report. Additionally, changes to the leverage ratio (SLR) could result in a recalibration of the enhanced ratio requirement based on the institution and/or exclusion of central bank deposits which may create more capacity and would be favorable for the market.
Trapp: Basel III rules establish the framework for agent lenders to calculate capital requirements to be put aside as a result of providing indemnification to clients. In December of 2017, the Basel Committee issued final revisions to Basel III, which included a more favourable exposure measurement for securities lending transactions and more balanced methodologies to calculate regulatory capital for banks and broker dealers under the Standardised Approach. A US proposal addressing the Basel revisions to the Standardised Approach would be a key development for the industry.
SCCL and NSFR are two important regulations that are yet to be finalised in the US. Similar to the Basel revisions to the Standardised Approach, adjustments to the exposure measure for securities lending transactions in the final SCCL rules would be a key development, particularly for agent lenders. The outcome for the NSFR rules could be meaningful for certain borrowers.
Specific to the EU, SFTR has received a significant amount of the industry鈥檚 attention given the breadth of the requirements and the scope of impact. Although the SFTR reporting regulation is specific to Europe, it will impact various securities lending participants in the US as well. The industry continues to make strides towards meeting the requirements, and vendors are engaged to facilitate collection and aggregation of the data elements required to be reported to the regulators.
Santoro: The current administration has been very clear on their stance regarding major regulatory reforms, and while we do not expect anything dramatically new, we do expect some long-pending regulations to crystalise. Conclusions to single counterparty credit limits, equities as an acceptable form of collateral for equity loans in the US combined with Bank Recovery and Resolution Directive and progress pertaining to Securities Financing Transactions Regulation in Europe will be welcomed by the industry in 2018.
Wolfe: The regulatory changes implemented over the last few years have resulted in a more resilient financial services industry. I haven鈥檛 heard of any major reforms that are in the works. And I would not be surprised to see an initiative in the US similar to SFTR in order to better equip regulators with data to enable them to monitor and fine-tune requirements. My hope for 2018 is to enable more of the market to realise the capital efficiencies and costs savings that are afforded to clearing within the current regulations.
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