What is the significance of the recent monetary policy shift in the major developed economies?
A year ago, a distinctive feature of monetary policies around the world was their divergence.
To some extent, these split mandates are now converging.
Here in North America, policy in Canada is more aligned with that of the US. Analysts are increasingly expecting a rate hike from the Bank of Canada in October.
In the US, the analyst consensus currently suggests a hike in December is probable.
For next year, in the US, forecasts at the time of writing suggest up to four more hikes are to come.
In March, the ECB reduced its bond-buying programme from €80bn to €60bn per month and has become more vocal about an additional paring back of quantitative easing (QE).
Analysts have noted that the supply of high-quality bonds that the ECB has pledged to buy under QE is dwindling, which will limit the scale and longevity of future bond buying.
Consensus expectations for the next ECB rate hike suggest it could occur between 12 and 18 months from now.
The consensus is not uniform however; there is a concern even within the ECB at the impact of a rate rise on the strength of the euro.
In terms of the impact of current monetary policy in our sector, unintended consequences of QE are still playing out in the form of the artificial downward force it provides on yields.
Add in the current global macroeconomic stress, which is driving a flight to safety on the part of investors, and you have another force depressing yields.
Alongside these continued downward pressures, we’re also seeing strong markets in equities across the globe this year in the US, the UK, China and elsewhere.
So we’re in this peculiar place where both major asset classes – equities and bonds – are gaining in tandem, against the historical dynamic that is typically associated with divergence.
Specifically, what impact is this having on demand for securities finance transactions?
I’d identify three main outcomes of this tandem support for bond and stock markets. The first is the continued march towards non-cash collateral.
With the majority of investors net long the markets, they are keen to finance positions using non-cash collateral rather than cash.
Non-cash has climbed to more than half our book now. In the second instance, the reduction of spreads in re-investment markets is tilting attitudes towards maturity and reinvestment risk.
This is largely a function of the corporate bond market, where we’ve seen a lot of mega issuance at investment grade levels, compressing the spread between investment grade and high-yield debt.
This has, accordingly, had an impact on the general collateral (GC) space. The third point to make is that, given the robust performance in equity markets, it has been a difficult time for short traders. Where it has happened, specials activity has been limited to specific sectors – such as pharmaceuticals or the recent Tesla issue in August.
In M&A, which is often the place where specials activity has proved most profitable, much of the recent activity has been in cash – not the leveraged deals that combine cash and securities – where there is very little in the way of arbitrage opportunities.
All of this means that, while M&A levels are strong and IPO activity has returned, the types of deals have meant demand remains relatively lacklustre.
Again this relates back to the wider corporate activity landscape.
The convictions from companies are just not there, so many are still sitting on their hands as they await clearer sightlines on policy and regulation.
In the US at least, the pace of regulatory change appears to be moderating. What impact is this having on the sector?
I think it’s reasonable to say that, looking forward, there is a smaller material amount of new regulation ahead.
There appears to be shared consensus on the street that the tone regarding SCCL (single counterparty credit limits for large bank holding companies) and the anticipated introduction of the Net Stable Funding Ratio (NSFR) under Basel III, for instance, is softening.
In general, there is not the same level of anxiety among participants that we have seen in previous years.
As an example of this shift, I would further point to the widely-debated revisions on the Supplementary Leverage Ratio – where we may see central banks’ deposits and government debt taken out of the denominator – which would have clear implications for our industry.
What is different from previous years is that firms are in a better place to deploy capital.
Capital preservation and growth are always going to be important, though strategic deployment towards risk-weighted assets (RWA) has become less of a headache today.
This direction of travel is set to continue.
Since last autumn the Fed’s Overnight Bank Funding Rate (OBFR) has replaced the Fed Funds Open (FFO) rate as the key benchmark for pricing and performance reporting.
Also coming up is the proposed replacement of Libor with an alternative benchmark.
The Financial Conduct Authority (FCA), the relevant UK regulator, is currently talking about adding a credit component onto a replacement dynamic, risk-free rate.
In the first case, the impacts of the shift to OBFR are still at an early stage. In the second, the replacement of Libor will represent a significant shift for the industry.
Depending on which source you look at, it is the pricing benchmark for $10trn of assets and another $300-$400trn of derivative instruments.
However, at this stage it is still a long way off.
The FCA announced in July that the measure would be phased out in 2021. None of this is to imply that some regulatory concerns do not remain.
Combined with recent global macro uncertainty – which has political as well as economic elements – continued regulatory awareness has helped to slow the market through Q3 which, as we know, is a traditionally slow season anyway.
But taking the longer view, regulation seems to be a more moderating influence than in previous years.
Has this had an impact on demand for term funding, too?
In general, the change of tone in the regulatory space is having an impact.
We’re observing that participants are less willing to pay the premiums necessary to go out beyond six months in term duration.
That said, the three-to-six month space is still active for both high-quality liquid assets and for equity- for-equity financing.
In the case of the latter, supply remains muted given the regulatory restriction imposed by Rule 15c3-3 (which prohibits broker-dealers from posting equities as collateral to counterparties such as US ‘40 Act funds).
I think as we see more details released on the regulatory front, firms will have a clearer idea of what balance sheets will look like in the coming years, which will determine what is available and what there is demand for.
Which areas of the industry is technology best placed to contribute to?
Technology continues to be a crucial driver of innovation for us, both internally – driving our internal efficiencies – and for empowering our clients, especially around execution, through the new services we are offering them.
We’re continuing to invest heavily in our front-end systems, to look hard at what else technology can deliver, as well as remaining active in a number of the industry work streams, such as those around CCPs.
I anticipate an even greater impact from technology going forward in the fixed income space, where the impact has hitherto been relatively meager.
What implications does this changing environment have for the health of the securities finance industry itself?
The absence of activity in the specials market is counterbalanced by the benefits of supportive asset prices.
These continue to provide a strong positive tailwind for the securities finance industry in general.
Appreciating equity markets have implications throughout the business, boosting the value of assets under custody and the fees that accrue from these, as well as boosting the fees earned on securities lending.
Certainly, businesses are growing again – and our business in particular. And the more settled regulatory environment has helped support decisions about how to deploy capital.
Notwithstanding these supportive forces, however, deploying capital efficiently is still very important.
We are focused on expanding our distribution channels, both on the supply and the demand side. But we are doing so in a selective fashion. We are certainly not aiming to be an inch deep and a mile wide.
We need a good return on assets, a solid return on capital and sustainable earnings growth.
This means taking a long-term view on sustainable growth: deploying capital efficiently does not mean jumping at every opportunity that comes our way.