Securities lenders are betting their future on transforming your collateral
The securities lending markets are finally coming to terms with the fact that it will never be a glad, confident morning again. Six years on from the start of the financial crisis, even agent lenders have finally conceded to themselves that the securities lending markets are not going to revert to the status quo ante the Great Financial Crisis.
These days, hedge funds are as likely to be net long as net short. The cost of leverage at the short end has risen permanently, putting an end to the yield curve play of the past. The borrowing appetites of proprietary trading desks – once so gargantuan that they drove hedge fund managers out of some investment strategies altogether – are much reduced, not least by the Volcker Rule.
Equity transaction volumes remain almost totally dependent on quantitative easing, and liquidity on high frequency traders (HFTs) whose appetites to borrow are the metaphorical equivalent of eating junk food: it is all about speed and volume. Any investment bank that wants to stay in the execution business has to service HFTs, but their main focus is on doing so at a cost acceptable to the management and the shareholders, which means greater use of technology and market infrastructure.
In equity markets whose activity levels are dependent on HFTs rather than “real” money, it is not surprising that the IPO markets are in the doldrums. This further depresses the securities lending industry, which has long counted on IPOs to create the selling opportunities that need to be covered with borrowed stock. Likewise, the mergers and acquisitions that generate higher demand to borrow “hot” stocks in order to sell them ahead of the consummation of the merger are also in the doldrums.
Last but not least in the range of depressive factors is the looming Financial Transaction Tax (FTT) proposed by the European Commission. As currently construed, it will apply to securities lending, with both borrowers and lenders paying 10 basis points on the value of any securities lent. The International Securities Lending Association (ISLA) warned in a paper published last week that this tax would “close down the securities lending markets” across 11 member-states of the European Union.
If ISLA has got its sums right, two thirds of the European stock loan market will disappear, taking €2 billion in incremental revenues for lenders with it. ISLA reckons securities lending fees would have to increase four-fold to make up the loss. If that happened, the wider implications are so serious that the neutral observer can only laugh at the ability of regulators to live with contradictions. After all, they are simultaneously increasing the demand to borrow eligible securities by driving activity into collateral-hungry central counterparty clearing houses (CCPs) and insisting all short positions are covered in advance via the Short Selling Regulation.
The regulatory burden is about to increase. The greater use of CCPs in the major securities lending markets is now regarded as inevitable. The Options Clearing Corporation, LCH. Clearnet, SIX x-clear and Eurex Clearing have offered services for some time, though they are not widely used. Brazil, where the CBLC acts as central counterparty to an increasingly important market, suggests the future lies with CCPs. They will almost certainly displace bi-lateral transactions (as they did in the repo markets) but not completely (as they did not in the repo markets).
Investment bank borrowers as well as agent lender banks will benefit, in the sense that CCP-intermediated trades will devour less of the regulatory capital devoted to securing counterparty risk (there are single counterparty exposure limits in Section 165 of Dodd Frank, and Basel III spreads the same limitation around the world). Agent lenders may also fear CCPs will eat their income, but regulators like them too much to forego their use in securities lending, and not only because they performed well in 2008. CCPs can also be used to collect data.
The appetite of regulators for data is so great that the securities lending industry is also bracing itself for the introduction of a trade information repository. That means more work – and so more cost – for agent lenders and their clients. Expectations are that the repository will want to see rates and dividend data as well as short positions, locates, securities on loan, and collateral provided. This will enable regulators to measure concentration, correlation and even systemic risk, but it will cost market participants time and money.
All this regulation and taxation is enervating lenders as well as borrowers. Contrary to popular perception, many investors have continued to lend in the aftermath of 2008. True, some have had to carry on lending to avoid crystallising a loss in a cash collateral reinvestment programme whose maturity stretched out even beyond today, but others because they still value the risk-reward ratio. But all lenders are demoralised to a greater or lesser by the lack of opportunities to lend. They are also more demanding of their agent lenders in terms of transparency, as disclosure is now known. They want lending returns attributed and benchmarked, as well as simply reported. Lenders that insist on segregated accounts and bespoke reporting will have to pay extra, or exit the market.
In this environment, agent lenders are desperate for new sources of revenue to cheer its lending clients up. One they never fail to mention is the emerging markets. These include Brazil (already a lively market), Korea (somewhat under-supplied) and Taiwan, Malaysia, the Philippines and both India (although non-residents are not allowed to participate) and China (which is engaged in a prolonged but reassuringly predictable de-regulatory process). Access to stocks from domestic investors will be crucial to success in emerging markets. So will the ability to manage the risks. All emerging markets have quirks and hidden risks, not just on the regulatory side, but in terms of execution and settlement too.
The other axis of growth in securities lending identified by agent lenders is – ironically, given the regulatory contradiction between their enthusiasm for collateralisation of risk and their hostility to stock borrowing - collateral transformation. The enthusiasm of regulators for CCPs will certainly drive up global demand for cash and eligible securities. The only way to turn securities into cash is via a repo or a stock loan transaction collateralised with cash, and the only way to turn cash into securities is by doing the opposite.
The important question is not whether desperate agent lenders and tri-party agents have driven the prospects for collateral transformation into hyperbolic territory (they have). It is whether agent lenders in particular will be willing to indemnify clients that lend into the collateral transformation transactions they host. After all, from the point of view of a lender, swapping CCP-eligible collateral or cash for non-eligible securities is a collateral downgrade, not a collateral upgrade. Agent lenders that do not offer an indemnity will be disintermediated since, without offering protection, it is hard to see what value they add.
Lenders must await the possibilities with interest, for the collateral transformation opportunity has yet to be realised on a major scale. Ultimately, it is dependent on the shift of long dated swap transactions from bi-lateral trades intermediated by investment banks into CCPs, in line with the Dodd Frank Act in the United States and the European Market Infrastructure Regulation (EMIR) in Europe. The first swaps went into mandatory clearing in the United States as recently as March this year, and European equivalent does not start until September.
But one aspect of securities lending will never change. This is the fact that the crucial determinant of earnings from lending securities is the contents of a portfolio relative to the demand to borrow those contents, not the scale of the appetite to borrow in general. If what an institutional investor owns is eligible at a CCP, it is in a good position to profit from the collateral transformation opportunity. But since a collateral upgrade for the borrower is a collateral downgrade for the lender, the lender needs to make sure the reward is commensurate with the risk. Once the costs of a CCP, a segregated account and bespoke reporting are added to the costs of a collateral transformation trade, it may not be.