Roundtable: US beneficial owners 2019

Roundtable: US beneficial owners 2019

Securities finance experts met in New York on December 6, 2018 to review the year and look at what's ahead for the business in 2019.

Participants:

  • Bill Kelly, Head of Agency Securities Finance, BNY Mellon Markets
  • Axel Hester, Director of Securities Lending, State Street Global Advisors
  • Anthony Toscano, Head Agency Securities Lending, Americas, Deutsche Bank
  • John O’Loughlin, Director, Portfolio & Cash Services, John Hancock Investments
  • Bob Hollinger, Partner, Barrington Partners
  • Brendan Eccles, Managing Director, Global Head of Securities Lending, Scotiabank
  • Bill Smith, Managing Director, Americas Sales Executive, JP Morgan
  • Nancy Allen, Global Product Owner, DataLend
  • Brian Yeazel, Managing Director, Fixed Income, Northwestern Mutual
  • Chair: Andrew Neil, Securities Finance Editor, Global Investor Group.

Chair: Borrower behaviour & revenue opportunities – where were they for lenders in 2018?

Nancy Allen: 2018 was very positive from a revenue perspective. Global gross revenue, as of November 30, was $9.3 billion, up 9% from 2017. Across the board, regionally and by asset class, the theme has been higher volumes and generally flat to lower fees. In the first three quarters, the rising markets resulted in greater on-loan values; however, as the markets sold off in the fourth quarter, lending volumes also declined.

As we hit mid-year, 2018 revenue was up 20% versus 2017. As of November 30, that gain was eroded to 9%. Global equity revenue was $7.3 billion through the end of November, up 11% as a direct result of higher loan volumes. Fixed income revenue was up only 2% at $1.9 billion, while regionally, EMEA and APAC revenue was up 20% and 32% respectively; both regions benefited from higher volumes. EMEA onloan balances were up 11%, and APAC 29%. In both of these markets, fees were slightly up. Americas revenue is a great example of the impact of rising markets in H1 versus the second half of the year. Midway through the year, revenue was up 9% on 2017, but ended the year down 4%.

In 2017, the top five names produced $382 million of revenue with a volumeweighted average fee of 347 basis points (bps) and an average on-loan volume of $11.9 billion. In 2018, the top five names contributed $465 million with a volumeweighted average fee of 305 bps, but an average on-loan volume of $15.8 billion. It’s been a volatile year to say the least for Tesla, the top-earning security year to date. Fees spiked up in February on the back of Model 3 production issues, and selling pressure continued into Q2. Then in Q4, Elon Musk announced that the company was close to being profitable, and Tesla then traded down closer to GC levels.

When looking at 2018 average supply, beneficial owners held $19.5 trillion of lendable assets across all beneficial owner types, including collective investment vehicles, pension plans, governments/sovereigns and insurance companies. US-based beneficial owners made up 51% of the lendable base. From an on-loan perspective, pension plans accounted for 32% of global volumes, followed by governments/sovereigns and then collective investment vehicles and insurance companies. The on-loan allocation makes sense as certain beneficial owners like 40 Acts and UCITS funds are subject to more restrictive guidelines.

Nancy Allen, DataLend

Anthony Toscano: It would be interesting to see the revenue trend lines from cash collateral versus non-cash, especially in light of the US having very robust money market investment opportunities. While volumes continue to rise, the revenue is really being generated on the cash side, especially in the light of the fact there are less specials, which Nancy highlighted. Secondly, it would be interesting to see whether ticket volumes have risen because naturally as specials have declined, GC has increased. It’s something that interests me a great deal, because most of my programme is not all that interested in high volumes/high turnover type transactions.

As far as borrower behaviour, we’ve seen European banks shift their trading books offshore to broaden the types of collateral that they can pledge. This forces US lending desks and lenders to adhere to different types of regulatory regimes such as SFTR and Mifid. I’ve been in the business for quite a few years and there’s never a dull moment, there’s always something new to tackle!

Bill Kelly: DataLend’s statistics are in line with our experience. The data shows that decisions have been made by select clients to take advantage of certain collateral or term flexibility opportunities. However, as Nancy pointed out, opportunities across the beneficial owner community are not equally available: pension funds and sovereign wealth funds have greater possibilities with respect to collateral or term flexibility. BNY Mellon’s securities lending volumes are up 30% year-on-year and a lot of that is in the fixed income space and driven by demand for HQLA. That trade has continued to trundle along and grow. For clients that have the right portfolio and the appetite for accepting different types of collateral and term flexibility, that demand for HQLA represents an opportunity. We’ve seen that throughout our programme and this aligns with Nancy’s data.

Bill Kelly, BNY Mellon Markets 

Bill Smith: Flexibility has become more important. Some clients have room to adjust based on a softening regulatory environment, which gives them flexibility to take advantage of more opportunities. Those opportunities surface in client discussions about where value could be added in a lending program, and can be identified with few key questions. Can you take advantage of term? Can you take advantage of the broadest collateral schedule out there? Do you have approved borrowers who are non- US borrowers, as some of the borrowers have moved their business more heavily overseas?

One thing we’ve seen is a continued march toward non-cash collateral, which has had a much more significant effect on some client groups than others. A number of the US-regulated clients can’t take advantage of equities as collateral, so this trend is not affecting them as favourably as it may be others. For clients who could take advantage of all opportunities, 2018 was a pretty good year, even though specials may have been a less fruitful producer of revenues than in the prior year.

Brendan Eccles: I would echo the sentiments around collateral flexibility, which is definitely the most important factor that’s been affecting our business. Over the last four or five years we’ve really been shifting drastically into noncash, it’s primarily off balance sheet and is generally more efficient for us and gives us the ability to grow our business without affecting our funding footprint dramatically. Customisation is also a really key point to the extent we can do collateral upgrade trades with lenders fitting our term needs. Those are big wins.

John O’Loughlin: We employ three lending agents to lend over 100 active lending funds. Our team exercises extensive operational and compliance oversight, and we also develop risk parameters and assess new opportunities in conjunction with our securities lending oversight committee. We believe having multiple agents enables the
Funds to create an internal benchmark and benefit from diverse capabilities and viewpoints, which allows us to better drive performance and mitigate risk. We’re not able to take advantage of some of the opportunities Jim and Bill spoke about since we run a 1940 Act programme, however, we began accepting non-cash collateral recently, and we’re seeing that open up certain opportunities such as lending in emerging markets. We have also seen significant demand for our ETF assets in the past year.

Brian Yeazel: A number of insurance companies have similar programme styles to ours. We have a lot of fixed income assets that we like to use as efficiently as possible and that makes an in-house lending programme for those types of assets particularly attractive for us. Given the financial strength of Northwestern Mutual there’s less counterparty risk when dealing directly with us. So, from a fixed income standpoint we’ve lent treasuries for decades directly to the street. The nature of that programme changed as banking regulation changed and made it more difficult for the street to carry the balances. We’ve all seen the shrinkage of repo books. The reinvestment side of the business is where we typically make our money in this programme.

One of the new developments we started in 2018 was going directly to other buy-side firms, in particular money market funds. As Bill mentioned, there’s huge demand for high quality liquid assets on the part of government money market funds and with the shift in the 2a-7 rules, more cash has been flowing into those funds and they’ve been looking for more opportunities to diversify the repo books. Northwestern Mutual is a natural fit for these shops, and we’ve found more demand than we could handle. We began lending treasuries directly to a couple of firms this year. Going into 2019 one of our new initiatives will be to develop our own tri-party platform to be able to not just deliver securities on a physical basis to other buy-side firms but to deliver them by our tri-party programme, making it much more attractive for those buyers to deal directly with us. I think we’re going to see a huge amount of growth there in the coming year.

On the equity side, on the other hand, we had for many years run an agent lender programme using an agent lender with us as a beneficial owner. We cut that back after 2008 and a couple of years ago we indexed our entire equity portfolio, so the opportunity set there has really disappeared. There’s just not room in our current investment mix to lend out our equities. So, we’re sticking with the fixed income assets, and again we see tremendous growth opportunity in the coming year.

Brian Yeazel, Northwestern Mutual

Axel Hester: The programs we oversee are all commingled, which limits us on the types of collateral we can take and our ability to do term. We run our programmes, which are global –Americas, Europe, Asia – largely on an intrinsic value basis. We use three different lending agents, and have designed each programme differently based on the different regulatory environments and markets. In the past year, we have been reassessing and tailoring our programme specifically for each region.
That being said, the remarkable bright light for the programme this year has been ETFs. The demand for ETFs has certainly broadened in scope, both the number of different ETFs being borrowed, and the volume of ETFs being borrowed has increased. The first half of the year generated attractive overall returns. Being an intrinsic value programme, for the last couple of months demand has diminished as special trades have waned. As far as the collateral upgrade trades, we don’t participate significantly. This isn’t something we’re chasing due to the limited intrinsic value in the trades.

Bob Hollinger: In terms of securities lending, we at Barrington, as consultants, are facilitators rather than executors. We’re neither a lender, borrower or agent. Our clients are typically 40 Act clients and they’re all using external agents. Some are doing internal collateral management and they’ve been extremely successful in the near term. Those who are using their agent to invest in an instrument of the agent’s preference are far less successful in terms of collateral reinvestment. We have clients who are making substantially more in collateral reinvestment than they are in lending - it’s been a good year for them. In terms of lending policies, all of our clients have closely controlled securities lending policies and strategies, and they’re very slow to change. Typically they’ve each established minimum spreads across all of their portfolios and, at this point, they are actively loaning ETFs where they have them. I have not seen anything that indicates the Boards are being more proactive in terms of modifying policies as they see the marketplace change. Generally it’s been a good year. Those who manage the collateral and invest it themselves have been extremely successful, the others less so. They’re realising as the dynamics change that they need to relax their guidelines to get more of their portfolios out on loan. That’s beginning to happen for some of them but others are still controlling lending a little too closely.

Chair: What are some of the traditional uses of securities lending data and what are some alternative uses?

Nancy Allen: Price discovery, liquidity and performance measurement are the traditional uses of securities lending data. What’s been interesting to observe is the evolution of data use as technology has advanced. Gone are the days when traders manually look up each security one at a time on their screens. Today, data is integrated into trading algorithms to facilitate automated trading over platforms like EquiLend’s NGT.

The traditional use of data by beneficial owners was usually in the form of statements summarising balances, earnings and perhaps year-over-year performance. Now, beneficial owners are demanding more from the data, including revenue attribution, over/underperforming securities and key revenue drivers. Performance measurement tools help beneficial owners evaluate agent lender performance relative to the market and other agents. Recently, beneficial owners started to consume data directly via data feeds or our new API in order to perform their own analysis, and that’s a big step forward. In addition, beneficial owners are analysing the data not only from a lending programme perspective, but they are taking a more holistic view and asking, “What can I learn from securities finance data? What is it telling me?”

Portfolio managers are using securities lending data for portfolio construction and to identify trading signals. Securities lending data is also a component of index creation, and non-securities finance trading desks such as traditional cash trading desks are looking at our data for insight into liquidity and fees. The use cases will continue to expand alongside growth in automation and technology as data providers continue to deliver data in a more consumable fashion.

Axel Hester: Our use of data is growing rapidly. At State Street Global Advisors, we are migrating securities lending toward a front-office function, and are receiving interest in data from portfolio managers regarding position liquidity and borrower demand. For us, data also becomes a valuable resource when you consider the development of new products and monitoring of our existing products i.e. – how liquid are our ETFs? How readily available are they to borrow? The data filters throughout the firm to all the different functions, forming an understanding for traditional portfolio management and product development teams.

Brian Yeazel: I absolutely agree with Axel. Over the years our portfolio managers have wanted more and more data, we’re not an intrinsic value programme, so the value comes from our cash investing. We are aggregating all of our investments and exposures, so we have to keep a very close eye in terms of how we have invested this cash. Interestingly enough it does end up resembling our general account fixed income portfolio quite closely, we have a mix of corporate bonds, commercial paper, some asset-backed securities, some very short-term mortgage-backed securities. As that portfolio has grown it’s impacted some of our exposures. Having information on a daily basis flow into the portfolio managers is critical for us to stay within our board-approved guidelines.

Axel Hester: One of the things DataLend and other industry providers have done well is developing user-friendly interfaces. Data that is more readily accessible - even if it’s not audited and 100% accurate – is easier to process, digest, understand and communicate than data in raw form.

John O’Loughlin: We leave the lending decision to the portfolio manager. As transparency has increased, and we let the PMs know about available data, they’re starting to come out to us to ask for revenue estimates and the impact of shorts on their long values. As a result, we are seeing more funds electing to participate in the program.

Nancy Allen: We offer our clients multiple different ways to consume our data. Most simplistically, data is provided over our Web-based screens or through an Excel Add-In tool. For clients who have the technology to integrate the data, we offer daily file feeds and a brand-new API designed for widespread compatibility with many software languages. Regardless of the delivery method, data quality remains critical. We put our data through a number of cleansing algorithms to eliminate outliers and duplications, and we continually review our data coverage focusing on the underlying contributors to our data set. The underlying dataset is extremely important for a beneficial owner looking to perform true benchmarking.

Bill Smith: Most of our clients have an appetite to consume more data, and the industry’s drive to transparency has resulted in a massive amount of data available. There’s a degree of efficiency with which the market needs to operate so that you’re not just providing any data to your clients but you’re providing data that matches what they need and answers the questions they’re looking to answer. We continually challenge ourselves to find the best ways to efficiently deliver data to our clients, and distil that data in ways to create value. Securities lending is moving in a direction where over the next two or three years it will become even more transparent, given the evolving regulations that affect both clients and the markets in total, both here and in Europe. The access to data, and the value added by analysis, is going to be key to clients going forward.

Bill Smith, JP Morgan

Bill Kelly: The interest from the asset owners in terms of receiving and consuming data has only grown. Information we provide to asset owners is being aggregated with third-party information across their programme. The other aspect of this is that some asset owners have an acute interest in incorporating this information as an additional view on the market. Perhaps their portfolio managers aren’t quite sure how to best use securities lending data yet, but I think they’re interested in receiving the information. To Nancy’s point, in terms of driving automation, we’re probably more data parameter-driven at present, but we’re on the precipice of developing more robust algorithmic trading capabilities.

Anthony Toscano: The data is readily available and invaluable. One of the real challenges is delivering it to the people who find it most impactful to their investment goals and to the people who can make decisions off of that data. The vast majority of the day-to-day client contacts, are using data mostly for benchmarking performance year-over-year,quarter-over-quarter, themselves versus the industry, rather than people making investment decisions based on the potential alpha generation is by holding the security. How we deliver that information to people to make those concrete investment decisions is important.

Data also needs to be explained. If we look at the proliferation of non-cash collateral in US, a blanket statement cannot be made without looking at increased volume by client types and what’s the percentage by client type?’ You might see a huge concentration of sovereign wealth funds with exposures to equities as collateral offshore. That may tell a different story to a mutual fund or pension fund. Clients still need a practitioner to help interpret data in order to provide the background necessary for making any changes to their programs.

Bob Hollinger: Our clients are accessing data more frequently. It’s available, and they’re looking at it but they don’t quite know how to analyse it themselves. So they’ve turned to their agency lenders to say, ‘Okay, you have the data, tell me how we’re doing on your programme relative to someone who mirrors us in the general marketplace.’ Therefore, they get vendor reports and that always show that they’re outperforming the general marketplace. Clients are getting more and more sceptical about the answers they’re getting from their agency lenders. So now they’re beginning to look for market data themselves and bringing it in-house; and trying to do the analysis to satisfy Board members who are asking, ‘How are we doing compared to the universe?’ So you’re right, it’s a hard question to answer, but I think there’s pressure from above, and from the side now, to make that happen. Otherwise they look like Lake Wobegon where they’re all better than everybody else.

Bob Hollinger, Barrington Partners 

Anthony Toscano: Comparing individual lending programme performance with the wider market is virtually impossible. But interestingly that comparison flushes itself out somewhat for mutual funds in the SEC filings for securities lending revenue.

Nancy Allen: DataLend controls peer group performance comparisons and algorithms, which cannot be changed by an agent. If a beneficial owner has multiple agents who provide DataLend performance reporting, that beneficial owner can rest assured that the peer group is controlled by DataLend. We conducted a survey about 18 months ago soliciting feedback directly from beneficial owners regarding their approach to securities lending and benchmarking. The overwhelming feedback was that securities lending is now viewed as an alpha-generating investment product, and therefore, benchmarking is necessary to monitor performance. The survey also confirmed that responsibility for lending is shifting from the COO or operations manager to the CIO or portfolio manager, which makes sense given lending is viewed as an investment product. That change is driving many of the conversations we’re having.

Chair: As rates rise, is there more value in securities lending for funds?

Bill Smith: Traditionally, rising interest rate environments tend to squeeze spreads, but can often stimulate volatility in the markets. Therefore, it can be difficult to determine whether it’s the rising rate or the volatility that’s driving value. Having moved off historically low rates, it is important to be reminding clients they can actually add incremental return from the investment side of their program. Hopefully over the next 12 to 24 months, this will give clients reasons to re-evaluate their investment model. In many cases, there may be return opportunities that will create a demand to expand cash collateral investments.

One example is prime funds. The impact of money market reform triggered some investment flows away from prime funds but, in the current rising rate environment, these funds have begun to demonstrate a significant spread over government funds. This may cause clients to re-evaluate their choices, and open their minds to looking at prime funds again. In the two years since money market reform, prime funds have also gained a lengthening track record of having near zero movement in their NAVs.

Brian Yeazel: First, I agree with Bill, it’s the volatility now that’s created differentiation in risk and reward. Now there are opportunities to take a little bit of risk and pick up some potential real yield. Generally what we’ve found over the 20 years we’ve run the programme is in falling rate environments we’ve made more money as prices go slightly higher, but our volumes tend to decline because the margins are squeezed when interest rates are low. Currently, the volumes can pick up as interest rates are rising but we’re giving up a little on the income. Every time there’s a rate hike you may fall a little bit behind the curve, but if you can try to anticipate the rate hikes and price it into your reinvestments you can stay ahead of that drop in your daily programme income. As I said, it’s giving us a chance to expand the volume that we have on loan and maintain our margins. We’re much happier with the current rate environment. 2019 will be very challenging because it was much easier to anticipate where rates were going in 2018, and I see the crystal ball is much cloudier next year in terms of what the Fed is going to do and how to price that risk. We’ll see what 2019 brings, but we’re happy with where rates are today.

Bob Hollinger: We’re seeing is - for those who manage internally but use an external agent - a very close, highly interactive day-to-day relationship between the client and the lending agent, so they can manage that cash collateral pool effectively.

Bill Kelly: We’re seeing tremendous interest from asset managers migrating into the prime space. To Bob’s (Hollinger’s) earlier point, they may be managing their cash themselves, so they’re comfortable with their process associated with the credit and risk decisions. It would be interesting to have this conversation a year from now and see where we’re at in terms of adoption and volumes.

Nancy Allen: In 2018 we saw a 30% uptick in revenue generated from cash reinvestment versus 2017, even though we had the same number of rate hikes in 2017 versus 2018. It would appear, as Brian mentioned, that funds were better positioned to take advantage of the duration mismatch in 2018.

Brendan Eccles: From a short-seller’s perspective, as the rebate you receive on your short sale proceeds increases, the cost of maintaining your shorts decreases. For instance, in a zero rate environment you have to pick a short that’s going to go down to make any money; in a 3% environment even if the price of the stock you short stays flat you still make 3%.

Anthony Toscano: There’s no question that the increased rates have given participants in securities lending more opportunities to generate income, but to demonstrate our experience here around this table it requires disciplines such as overall duration, liquidity; and that’s real overnight liquidity. A view across your program that dissects where the cash collateral is coming from. You can run a short-term cash strategy with all the bells and whistles but it needs to be managed with a close eye on the loan side (which I refer to as the liability side of the ledger) to ultimately maintain the risk reward that clients who are looking to “earn incremental income on idle assets” have really signed up for. The same holds true for all commingled investment vehicles. I’m always interested in how many other securities lending agents invest into these funds.

What percentage in aggregation are all securities lenders in these funds? Because money comes in for one reason and it all goes out for the same reason. But it’s an effective tool and, when managed properly, can really lead to some record earnings. Also, those funds have much more liquidity than they did prior to money market reform.

 Anthony Toscano, Deutsche Bank 

Chair: Tesla CEO Elon Musk has recently been critical of securities lending – do such comments highlight a lack of understanding of this industry? Is this type of attention good or bad for the business?

Bob Hollinger: One benefit we saw from Mr Musk’s exposure in the trade press was that we’re continuing to have discussions with clients who either are sitting on the side line or have never lent. His comments got the attention of so many senior management and Board people who then wanted to say, ‘I don’t understand lending, can you help us understand?’ We’ve done a lot of educational meetings with people that never were willing to even talk about lending. It became the topic de jour for a while. I would say it was good for the business overall, just because it stimulated conversation.

Anthony Toscano: He is not the first CEO to comment about securities lending. For me any criticism highlights the fact that this over-the-counter product has no counterweight when someone comes out and makes a broad statement about the entire industry. It’s left to people in this room to individually address these things, which is difficult. We don’t get together and rehearse it, we’re all saying the same thing but in a slightly differently manner and information gets interpreted differently. Of course, his social media platform is over 20 million followers and people make snap judgments but active managers have to look at securities lending because passive managers have already embraced the fact that alpha generation is limited to a certain number of leavers and one of the largest leavers is securities lending. If you don’t pull that lever you’re likely to l have a tracking error amongst your peers.

Bill Kelly: Active managers have probably been more selective in terms of securities lending in the past, but because of the momentum that passive strategies have had in accumulating assets over the last several years, active funds are now embracing and examining securities lending and overcoming their philosophical reticence because they need to be able to compete. We’re seeing asset owners and asset managers wanting to be in a position that they can reduce the economic unit cost for their shareholders by participating in lending and basically netting off against the advisory or management fees.

Brendan Eccles: There have been some really interesting stories this year about ETFs and fee compression, which have led to a lot of discussion around securities lending. There’s no better evidence of direct benefit to the consumers and people that are in funds involved in securities lending than saying, ‘You don’t pay a fee on your ETF anymore because we’re good at lending out securities.’ That coupled with empirical evidence that the market is more liquid and transparent with all opinions reflected. You can liken it to the real estate market, or the cryptocurrency market this year. Some of the biggest investors in the world came out and said, ‘Bitcoin is a joke, it’s going to zero,’ and the price of Bitcoin continued to climb close to 20,000 but no one had a way of reflecting their negative opinions, and then you saw a huge crash. Is the market better with a lot of opinions resulting a more accurate price, or is it better to have these price balloon and bubble bursts?

Brendan Eccles, Scotiabank 

Chair: Leverage and capital constraints on this business have been well-documented. How well has the industry adapted? What more needs to be done?

Brendan Eccles: In terms of leverage and capital, we’ve seen firms get much more efficient. Firms are really starting to look at, ‘What am I short and what am I long, and how can I net those positions off?’ That’s been a big driver for some of the equity for equity businesses, if you don’t have to bring cash into the transaction at all it certainly benefits capital and balance sheet usage. The other thing we’ve seen people do is proactively work with their customers. There’s a lot more active dialogue with hedge funds now in terms of what assets we as prime brokers are being asked to finance. We’ve been able to get to a much better asset mix from customers, and the sophisticated customer base that we see is happy to finance securities that are most efficient for us to finance. Every company is slightly different in how the capital rules affect them.

Bill Kelly: Borrowers have unquestionably become more efficient in recent years, while agent lenders have quickly caught up in terms of trying to put capital efficient structures in place. Pledge models are providing an opportunity for delivering greater capital efficiencies to borrowers and we are seeing improved spreads with borrowers that have agreed to pledge. It’s important to recognise that not all borrowers have the same constraints: some might have risk weighted asset (RWA) constraints, while others are constrained by capital and leverage. There may also be firms with no constraints depending upon
jurisdiction, so it’s going to vary. The CCP option is also out there. The market is adapting between pledge netting and CCPs to try and make lending programmes more attractive for both borrowers and lenders in terms of reduced consumption of financial resources, such as liquidity and balance sheet.

Anthony Toscano: Regulators have created different values for the same security - due to no fault of the beneficial owner - just because they’re characterised as a particular risk-weighting. It’s forced us to develop tools, whether it be pledge structures or CCPs. With CCP’s, I’m very concerned about a herd mentality for the securities lending market where people just voluntarily participate in lending, not because they have to or that is core to their investment strategies. The agent lenders that get closer and closer to whatever the concerns are of the counterparts and understand their binary constraints and their ability to be nimble when facing off with those binary constraints to the benefit of their client, will have better results and that’s what I’m trying to work towards.

Bill Smith: Pledge is a great example of change: it’s not radically different, but there’s probably a window where those who do more of their business in that way will earn more than those who don’t. There’s a window of opportunity here and there may be rewards for early movers.

Chair: Do you expect connecting to and transacting via CCPs to become commonplace in this market? If so, when?

Axel Hester: Central clearing of securities lending transactions sounds like a great idea, but has its own challenges. One current problem is that the solution developers are focused on solving problems for a certain subset of stakeholders, but are not improving outcomes for all the stakeholders. In other words, they’re trying to push a cart forward with two horses pulling in the other direction. Is there a solution here that makes sense? I hope so. It could make everyone’s balance sheet much more efficient across the board. Right now the solutions we’ve seen don’t consider the needs of the beneficial owners or some other parties that are involved in the transactions. To be successful, all stakeholder concerns need to be addressed.

Axel Hester, State Street Global Advisors 

John O’Loughlin: Aside from the regulatory hurdles in the 40 Act space, we need to understand how the CCP model would work for a program like ours. Would there be a premium to go through a CCP? How would an agent model and indemnification work? How close is the industry to solving these issues? While it’s not clear currently how a beneficial owner that manages its own cash would benefit, we will continue to monitor the opportunity as it becomes an alternative route to market.

Brian Yeazel: It’s a great solution for some parties but not for all of the parties to this business. The way in which it was initially proposed was particularly burdensome for the buy side in terms of the expense and the unlimited potential if something happened to the CCP regarding capital exposure. That was one of the major concerns that we had. I think if we can find a solution - much like you would have with a futures exchange where through an executing broker – it has to be workable for the buy side. I am sure there would be some cost with that, just as there is transacting out of an exchange, but it would be a defined cost. That’s really what the buy side needs to see, ‘I know what my cost is, it’s not unlimited liability at some point down the road.’ If we can get to that, we can build those costs into whatever solution we come to.

Nancy Allen: We established EquiLend Clearing Services (ECS) to provide connectivity to CCPs globally, because we believe that there are balance sheet efficiencies and opportunities for clients who may not have a favourable RWA to put those trades through the CCP. In the future, the single counterparty credit limits could also drive businesses towards CCPs. I would agree with the comments around the need for inclusion of beneficial owners and agent lenders in the structure. There are initiatives underway now to put programmes in place that work for the agent lender and for the beneficial owner.

Anthony Toscano: The issue is that centrally cleared business is going to happen for securities most readily available. Securities that people are willing to pay hundreds of basis points to borrow will continue to be cleared bilaterally regardless of the capital cost associated to the counterpart. So what we’re talking about is the high volume/lower spread transactions that need to be centrally cleared in order to make them more cost effective.

Bill Kelly: The FICC sponsored membership programme for cleared repo started a few years ago. From relatively humble beginnings it’s gone on to eclipse the Fed’s repo programme. How does the securities lending market build upon that? It’s probably going to be in the higher volume/ lower spread activity where the capital advantages are really most valuable.

Chair: To what extent will US lenders seek out-of-scope borrowers when Europe’s SFTR reporting takes effect?

Axel Hester: We are expecting to participate, and will lean on our lending agents to provide reporting for us. There isn’t a lot of discussion about the matter. We don’t expect it to change our decisions around what we lend or where we lend. We have funds in the European Union (EU) that are going to be subject to the requirements, so we will proceed, and the cost hopefully will be spread across a sufficiently large asset base to make it palatable. We recognise that there’ll be incremental cost for the lending agent, which is a factor that will need to be considered in negotiations, but we don’t expect it to change our decisions.

John O’Loughlin: We understand our lending agents have the heavy lift here. Our lending decisions would likely not be impacted unless the funds incurred the costs.

John O'Loughlin, John Hancock Investments 

Bill Kelly: If you think about SFTR and the potential cost, there’s no industry solution; it’s firm by firm, relationship by relationship and involves bespoke solutions. Then you have pledge and netting complexity to add into the mix. In my view, asset owners will either continue to lend as normal or insulate themselves by saying, ‘I’ll only lend to a US borrower, and if I can’t, I’ll limit my activity’.

Chair: What’s the outlook for the business?

Bill Smith: 2018 was a year of good progress. We continue to see institutions reengaging after having remained on the sidelines, and growth in first-time entrants into lending programs. This is a good bellwether for continued growth of the lending markets and a broader understanding of the value potential of a lending program.

Nancy Allen: From a DataLend perspective, we’re focused on our relationships with beneficial owners and are pleased to be partnering with agent lenders to support beneficial owners with fiduciary management and oversight of their securities lending programs. Beneficial owners are looking for transparency, standardised performance measurement and data that is reliable, cleansed and easily consumable. Not only are beneficial owners utilising data for the management of their lending programs, but they are also incorporating securities lending data into broader strategies throughout their firms.

Bill Kelly: I agree the industry is healthy, although there was a dearth of equity specials in 2018. Perhaps the pipeline of M&A activity presents more opportunities in 2019, and that would be interesting. With volatility, geopolitical and regulatory factors, greater intrinsic value may drive returns going forward. We’re a contrarian business, which is not necessarily good for long holders, but we also provide a salve to some of the downside, enabling them to seize the opportunity and generate alpha.

 

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