Why Lending Is Looking Up
November's surprisingly potent US jobs report once again raised speculation that the Fed would finally deliver on its promise to boost interest rates before the year was out. Even so, yields are likely to remain below historical averages for some time, compelling many asset managers to continue seeking alternative alpha-generating strategies, securities lending included.
Beneficial owners can choose from a number of plausible strategies on lending revenue generation, ranging from structured transactions such as collateral upgrades to high-quality, government-backed assets, which continue to grow in demand. Many see collateral flexibility and acceptability as key drivers of securities lending innovation. Meanwhile, demand for more efficient capital-management solutions could pave the way for broader CCP acceptance within the US lending community.
Post-2008, securities lending has frequently been targeted by global regulators, including some who consider the practice unfit for institutional consumption. Though intended to reduce volatility, the increased emphasis on lending transparency could act as a deterrent by weighing on returns. Despite some industry pushback, efforts by agencies such as the Financial Stability Board to increase securities lending due diligence will ultimately benefit the business as a whole: the more investors know about lending, the more likely they are to want to be involved. While tougher guidelines could have some impact on spreads, lenders must get out of the dark and into the new era of increased clarity.
The securities lending industry has changed dramatically since the halcyon days of 2007-8 when lending volumes were at their apex. Then, lending was very plug-and-play for investors – a custodian would typically handle the securities selection process and soon returns would arrive. Then came the fallout of 2008: suddenly, investors wanted a separately managed, customised program, with the ability to dictate specific investment guidelines or, in some instances, handle the investing themselves. Solutions for comparing like-to-like, agent-lender performance and risk-management capabilities have since risen to the fore as well, as has service customisation, including bespoke programs tailored to owners' specific risk-return characteristics.
Maintaining a viable securities lending operation, while ensuring that programs accurately reflect a client's risk profile, can be challenging for agency lenders. Objectives may vary greatly from one owner to the next (a hedge fund, for instance, is likely to have very different expectations to those of a plain-vanilla asset manager, public or private pension-fund manager, or other risk-averse entity).
The ability of lenders to tailor programs to a client’s specific risk characteristics has therefore become a compulsory element. Naturally, much depends on whether a client views lending as a purely ancillary product or, by contrast, is amenable to increased risk exposure in order to help meet unfunded liabilities or generate additional alpha for the investment portfolio.
Accordingly, information for beneficial owners must be easy to understand and customised to their specifications; lenders should also hold regular discussions with CIOs to ensure that the structure of the lending program continually meets their guidelines. Having a diversified, risk-managed, asset allocation covering a broad range of potential borrowers can also help owners optimise their lendable supply, while also mitigating risk.
Participants also need top-shelf technologies to ensure streamlined lender-owner communications. Advanced, dashboard-based reporting mechanisms offer clients a more holistic view of markets; for those with a higher risk appetite, tools such as stress testing allow owners to accurately access cash-reinvestment risk in real-time.
In the US, short-term liquidity coverage ratio (LCR) guidelines include the provision that banks' 30-day net cash outflows consist of high-quality assets (with cash and government-backed securities holding a most-favoured Level 1 weighting). As a result, borrowers have been increasingly sizing up collateral optimisation strategies, as well as treasuries-for-term and other financing arrangements built around highly liquid assets. (BNP Paribas' agency lending business currently has 95% of its high-quality, liquid assets out on loan.)
Meanwhile, the ongoing quest for capital efficiency continues to propel centrally cleared lending as participants look for new ways to offset the cost of raising capital in order to satisfy leverage-ratio requirements under Dodd-Frank and Basel III.
According to 2014 research by consulting group Finadium, over 40 per cent of asset managers and insurance firms believe that clearing loaned securities through a central counterparty (CCP) could reduce or eliminate altogether the need for borrower default indemnification.
To date, CCP lending has been almost exclusively the domain of Europe. (Chicago's Options Clearing Corporation remains the lone Stateside CCP provider). One reason for this is Europe’s historical preference for non-cash collateral – in stark contrast to the US which, prior to 2008, utilised cash for nearly 90% of lending collateral.
However, it is likely that the US will soon catch up with its EU counterparts, thanks to efforts by the Risk Management Association and the Securities Industry and Financial Markets Association to amend Rule 15c3-3, which prohibits the use of equities as collateral among broker-dealers in securities lending arrangements. While it could take several years for these changes to occur, agents should act now and begin sharpening their collateral skills in order to ensure viability in an increasingly non-cash world.
With interest rates offering little in the way of support, asset managers remain open to viable alpha-generating opportunities, assuming specific due-diligence standards are satisfied. Giving beneficial owners greater access to information such as counterparty creditworthiness, on-loan securities valuations and other integral data will help keep participants in the game, while encouraging those still on the sidelines to get involved again.
Although the needle has barely budged in recent years, the continued strength in US equities, along with the potential in fixed-income opportunities, suggests an upswing in lending volumes going forward. Many beneficial owners who had abandoned lending post-crisis have since returned to the fold, confident that proper safeguards are now in place. And with good reason: even for the most conservative-minded, an extra five to ten basis points derived from lending can make a palpable difference at year's end. While demand fundamentals continue to be somewhat muted, due in part to more stringent capital, leverage and liquidity requirements, the future still holds promise for the business of lending.
Read this article as it appeared in Quintessence magazine (Winter 2016)
"Why lending is looking up"