To boldly go…
Keeping a close eye on securities lending for asset holders.
Keeping a close eye on securities lending for asset holders.
Financial markets have witnessed the evolution of new and enhanced regulations. They have fundamentally changed the securities lending market from one of a mix of disparate regulatory frameworks to central regulation through investor guidelines, market directives and direct policy. With the express mandate to create stability across financial markets, these new regulations are also compelling asset owners to re-evaluate the risk vs. return dynamic within their securities lending programs, and how they effectively measure performance success.
Asset owners today are confronted with insufficient returns across many capital market activities. For insurance companies specifically, the ratio of return on liability-driven investments to risk has been too low for too long. This prolonged period of ultra-low interest rates is now biting hard and negatively impacting long-term investors, in particular those whose investments are concentrated in government bonds. To intensify the situation, insurance companies are subject to portfolio allocation rules which provide little scope to look further afield in search for yield. So while earnings are depressed across many products and insurers have to consider a narrower range of investment options, the returns on offer in today’s markets are no longer sufficient to support the long term investment strategies that insurers have relied on in the past. Furthermore, with global interest rates set to stay low, and in some cases negative, for the foreseeable future, investors have to take a fresh look at investment strategies and where value can be extracted on a risk adjusted basis.
The current interest rate environment has a second, counter effect on insurance company liabilities; as risk-free discount rates move ever lower, this shift automatically increases liabilities, exacerbating the asset/liability investment gap.
Insurance companies are not alone in the search for investment yield. Investors across all markets not only face the challenge of diminishing returns with low interest rates, but more critically, protection against the erosion of principal, in a negative interest rate environment.
Pension fund investors operate with a similar long-term liability profile to insurance companies. In the private pension sector in particular, an increasing number of schemes in recent years have reduced the offering of defined benefit schemes in favor of defined contribution schemes as shifting demographic trends have compelled investors to realign attainable returns with projected liabilities. Similar changes are also afoot in the UK public sector pension market, where Local Government Pension Schemes are now pooling investments and aligning strategies in an effort to reduce operational costs and generate investment economies of scale.
Additionally, central bank and sovereign wealth fund (SWF) investors have also suffered from a ‘perfect storm’ of low/negative global interest rates, geo-political tensions and risks and slowing global growth driving a dramatic slump in global commodity prices; an asset class where many SWF investors have typically grown in size to the value and position they enjoy today.
To address the mounting pressure on investment return and principle, asset owners are driven to take a closer look at investment portfolios for intrinsic value and return in areas that may have, up until now, been under-explored.
Notwithstanding the compelling regulatory and market headwinds investors see today, opportunities to generate securities lending revenue remain strong. Many investors are well placed to benefit from the variety of different market conditions and trading strategies available in the securities lending market today. In particular, opportunities remain strong in the economic divergence taking place across APAC and Emerging Market economies as a result of the shift in global growth and commodity demand dynamics, through targeted European equity activity focusing on M&A ‘specials’, equity SCRIP dividends and the lending of High Quality Liquid Assets (HQLA) across the fixed income markets.
A weaker EUR/USD coupled with an array of ECB asset purchasing programs have helped stimulate lacklustre Eurozone economies; the benefits of which will materialize through an increase in cash equity market volatility with corresponding borrower demand. Additionally, the weak Swedish Krona has also helped stimulate economic growth in the Nordic region, supporting lending fees and demand across investor lending programs for 2016.
In recent years, the overall size of securities lending programs has become less of a focus for lenders as regulation has curtailed bank and broker-dealer proprietary trading activity and balance sheet usage, resulting in the volume of quality securities supply to the market outstripping demand. Lenders are now looking to identify and take advantage of different revenue opportunities deriving from market conditions and strategies. Capital markets and investors today find themselves operating in unchartered waters. This unique environment has resulted in a fundamental change to the rationale for securities lending activity. Once considered an activity providing a ‘top-up’ revenue stream for asset owners in a positive spread and investment environment, it is now being viewed by many as a critical consideration to optimizing the performance of a pool of long term investments.
With a continuing trend towards tax harmonization across European markets, institutional investors establishing discretionary securities lending programs are benefitting from the increased level of control and flexibility they have over their programs, while at the same time tailoring them to deliver upside revenue potential from all available trade opportunities.
Demand remains strong to borrow mid-cap and small-cap equities to ensure transactional settlement of directional short positions, and high fees continue to reflect this demand. By remaining in a securities lending program, asset owners will continue to benefit from the high spread, low volume activity that generates additional income to their funds. Additionally, SCRIP dividend opportunities continue to flourish as a means of rewarding equity investors, and borrowing fees also reflect this demand. The shifting global economic growth patterns seen today will ensure market activity and demand across specific assets will remain for the foreseeable future.
The regulatory demands placed on banks under Basel III continue to drive demand to borrower HQLA, such as government bonds and supranational bonds, with combination demand seen in open and term loan transactions. Specifically, the European Central Bank (ECB) Public Sector Purchasing Programme (PSPP) has fuelled borrowing demand for European Government Bonds (EGBs) in the securities lending market and asset owners typically holding HQLA, such as insurance companies, central banks and sovereign wealth funds remain well placed to benefit from this demand and well positioned to consider term lending opportunities of varying maturity.
Opportunities also continue to prevail for asset owners of corporate debt, as the global contraction in commodity and energy markets continues to produce high spread specials. Moreover, the ECB’s Corporate Sector Purchase Programme (CSPP), set to begin in June 2016, is beginning to fuel an increase in foreign debt issuance into the European corporate market in anticipation of the CSPP driving down borrowing costs for corporations able to issue debt through subsidiaries in euros. These developments alone are creating significant opportunities for asset owners searching for yield, in such a low interest rate environment.
As mentioned, strong revenue opportunities persist for investors lending HQLA, but what is accepted as collateral is fundamental to the success of the transaction. With the pressure on banks and broker-dealers to manage their balance sheets over regulatory reporting periods, in line with prescribed liquidity and funding ratios, the ability of lenders of HQLA to accept collateral of a lower credit quality, is key to these loan opportunities. Such loan transactions are often referred to as ‘collateral upgrade/downgrade’ transactions and there are several factors that lenders should consider when reviewing both open and term lending opportunities accordingly. Asset owners should expect their lending agents to develop and operate a well-structured and counterparty diversified lending program with a laddered investment approach to term opportunities; optimizing the attainable risk adjusted returns for the asset owner.
The message is as true today as it was in the 1960s sci-fi television series, Star Trek: the key to living long and prosperous in the changing markets, in which we operate, depends on the continuing development of revenue enhancing investment strategies and technological innovation. This idiom remains true for the continued success of any financial product and service.
As interest rates have fallen across global markets to the levels seen today, investment practices and approaches to how we think, provide both challenge and opportunity for investors. As an industry that has been subject to a paradigm shift in oversight and focus through a mix of regulatory frameworks and best practice origins, to quite possibly one of the most heavily regulated investment practices in today’s markets, the ability to seek opportunity and adapt to changing market conditions are key to the survival and success of a securities lending program.
Consequently, asset owners across multiple investment categories are still taking advantage of the investment returns available through a well-designed and managed securities lending program. Markets, by their very nature, will always change, and so will the challenges they present and opportunities they provide. The securities finance industry is already witnessing advances in the application of new routes to market for asset owners, utilizing central counterparties (CCPs) and synthetic trading techniques. Banks and financial institutions are also beginning to explore the possibilities behind the application of distributed ledger technologies, such as the blockchain. Such innovations, if adapted and implemented for the mutual benefit of all market participants, will create further opportunities and ultimately investment returns for asset owners.
This article was originally published in the Securities Finance Monitor, June 2016.