As industry participants still get to grips with GITA and the drop in demand for German securities, further challenges surround SFTR and the effects of Brexit
At the time of writing, the German market, and the rest of the EU is preparing for Brexit with the date forecasted to be 12 April, a delay on the original deadline of 29 March. However, the bigger challenge for the German securities lending market will be preparing for the upcoming Securities Finance Transactions Regulation (SFTR), which is due to be fully implemented next year.
In addition, there has been a notable drop in demand for German securities. Industry experts predict that opportunities for the upcoming years in Germany lie in the technology space around blockchain, artificial intelligence (AI) and machine learning (ML).
Last year saw the implementation of the German Investment Tax Act (GITA 2018), which introduced the taxation of manufactured dividends and lending fees on German equities. The Manufactured Dividend Rule renders securities lending and repo income subject to a 15 percent German taxation in the hands of a lender and repo seller, respectively when such lender or repo seller is an investment fund. It also modifies the taxation income by creating two tax regimes, one for non-tax transparent investment funds and the other for transparent special funds. Prior to GITA 2018’s implementation, the rule was described as murky, inconsistent and unnecessary.
Today, the market is gradually becoming more adept to deal with these new rules. Commenting on GITA, which was implemented on 1 January 2018, Andrew Dyson, CEO of the International Securities Lending Association (ISLA), says: “As the market considered how best to comply with these new rules and the potential obligations on the borrower to apply German withholding, many underlying lenders and their agents stood away from the market.”
He explains that this has “resultant impacts” on both overall supply and market volatility. However, he says: “As we move into 2019 the market is learning to work within these new rules yet remaining cautious.”
One industry expert notes that Germany has seen some fundamental changes over the past few years, and explains that the introduction of a 45-day holding period and a restriction on the level of hedging allowed dramatically reduced the demand for German securities.
The expert alluded to GITA, which reduced the liquidity quite dramatically for certain fund types. Interestingly, for those funds that were deemed ‘out of scope’, there was an increase in demand in 2018, and demand outstripped the available supply in many securities.
So far this year, the expert suggested, we have not seen the same level of demand—mostly because some of the initially restricted inventory is now available and returns have been muted to year-to-date. Expectations are that the German market will not return to its previous levels in the future, which could potentially impact German market liquidity going forward, the industry expert explains.
Ali H Kazimi, managing director, Hansuke Consulting, comments: “The cross-border German securities loan market has contracted significantly on account of the different tax measures. Lenders and borrowers have made their absence felt, particularly during dividend season.”
“An interesting development in the course of 2018, was the court decision in relation to a historic corporate action in respect of MAN SE. This has raised interesting issues for both the borrowers and the German investors within the lending mutual fund. The action raised pertinent tax technical issues such as whether the cash amount received by the beneficial owner could be classified a dividend under German tax law.”
Getting to grips with GITA
Kazimi explains that GITA introduced measures to clamp down on trades between foreign—for example, non-German resident counterparts—and German resident shareholders around the dividend date of the shares.
He asserted: “Such trades, according to the authorities, were motivated by a desire to monetise the German withholding tax credit on the distribution (the so-called “cum/cum” transactions). To be eligible for a credit of German dividend withholding tax, under the measure, a German shareholder has to have owned the shares for at least 45 days during a window period of 45 days before and after the dividend distribution date. In addition, the shareholder must bear at least 30 percent of the risk of a change in the value of the shares during that period. This had the net impact of driving liquidity away from overseas loans of German securities.”
Discussing GITA’s significant effect on the supply, one industry expert highlights that the majority of in-scope lenders do not want to assume the German tax self-assessment compliance obligations triggered by receiving securities lending payments from non-German borrowers that are subject to a German corporation tax charge under GITA.
The industry expert suggests: “Many have curtailed their loans of German securities accordingly. In some circumstances, this reduced supply has had the effect of squeezing borrower demand and created upward pricing opportunities for lenders that have been able to remain active in the German market.”
“However, as a result of Brexit, London-based borrowers who relocate their trading function to Germany will be considered German resident borrowers and therefore responsible for collecting the tax due under GITA with regard to manufactured payments. This change should, therefore, help lift the tax GITA compliance obligation from those in-scope non-German lenders and help provide a progressive increase in liquidity.”
Simon Heath, regional head of agency securities lending for Europe, the Middle East and Africa at J.P. Morgan, affirms that the German equity lending market has seen revenue growth despite changes in regulation, which affected the lending market ahead of GITA.
Heath recalls that in the run-up to the implementation of GITA, the German lending market did witness a dip in equity availability, as in-scope positions were recalled from the market ahead of the new regulation deadline.
He says: “There may not be a direct correlation between GITA and this decline; however, it cannot be ruled out as a contributing factor. Conversely, demand remains strong and has been centred on stability and thus the communication between the beneficial owner, the agent lender and the borrower. It is clear that sourcing stable stock has become a priority by borrowers compared to 2018.”
In terms of fixed income, Heath highlights that German sovereign lending has been a standout asset class for a number of years. After a relatively subdued start to 2019, there have been a gradual increase inflows across the German sovereign space, he said.
He continues: “As such demand for bunds—and other high-quality liquid assets (HQLA)— in collateral upgrade structures (especially against equity collateral) has declined somewhat versus the same period in 2018.”
Heath suggests that J.P. Morgan is also seeing pricing pressures on remaining trades.
He explained: “In the repo market funding rates have continued to cheapen as balance sheet pressures have abated significantly, while on the demand side, the decline and end of the European Central Bank’s purchases have contributed to a reduction in distortion of the curve. As a result, there have been fewer opportunities for relative value funds which are reflected in lower specials in 2019 and further tightening pressure in cross currency basis markets.”
BaFin’s ban on short selling Wirecard AG
Elsewhere, in Germany’s market, the German financial regulator, Federal Financial Supervisory Authority (BaFin), halted short selling on Wirecard AG due to its falling share price causing uncertainty in the market. BaFin indicated a decrease in the Wirecard share price occurred between 30 January and 15 February 2019.
Christian Schablitzki, managing principal at Capco, Germany, highlighted that BaFin’s decision to ban short selling in Wirecard AG for two months through to 18 April to prevent potential negative impacts on the German financial system stemmed from the fear that any ‘erratic losses’ in Wirecard stocks could have spill-over effects to other financial stocks, such as Deutsche Bank or Commerzbank, both of which were trading at relatively very low levels.
Schablitzki notes that the ban is more to do with maintaining overall financial stability than to Wirecard AG, which represents some 1.25 percent of the total value of the German DAX.
Reflecting on the effects of the Wirecard ban, Dyson exclaims: “Reactions to the decision to suspend short selling in Wirecard were mixed. On the one hand, many felt this was a strong stance from the regulator, while others felt that all that short sellers had done was to focus attention on certain alleged accounting and financial fraud allegations within the company.”
He continues: “We should not forget here that all short sellers are doing at one level is to simply express the sentiment in a particular security. What is clear here is that the current short selling rules that apply across Europe that require any short positions to be against an identified borrow or locate, do appear to be working although the debate still continues about the role of the BaFin in this particular case.”
Kazimi says: “The market intervention is being looked at seriously. Obviously, if there are going to be regular regulatory interventions to restrict covered short sales, that will eventually drive down the demand for securities borrowing.”
Client trends in Germany
Discussing what trends can be seen from clients in Germany, Dyson noted that ISLA does not have many direct relations with underlying clients in Germany so it is hard to be precise. He expands: “The feedback that we have received suggests, however, that many institutions are actively looking at securities lending either for the first time or returning to the market after standing away from this market post the financial crisis.”
Tom Riesack, executive director at Capco, Germany, cites: “In terms of securities lending, we do see a focus on global issues such as the Interbank Offered Rate transition and regional considerations such as Brexit and SFTR. Markets in this low-interest environment offer low margins, and we are seeing some concentration of business at larger players/incumbents. On the technology front, there are ongoing discussions around how best to reduce the costs associated with securities lending by simplifying the technology stack. And collateral is once again re-emerging as a bigger focus as firms assess how it can be optimised across product silos.”
Heath inferred that J.P. Morgan is seeing a rapidly evolving shift in the traditional role of agent lender from one whose focus was generating portfolio returns via securities lending to a more holistic facilitator of a client’s overall collateral strategy in Germany and more widely across EMEA.
He adds: “The functionality and connectivity in place for a securities lending programme can be adapted very well to optimising a client’s asset pool, allowing collateral and regulatory obligations to be met across different venues and exchanges while ensuring more “valuable” securities from a lending perspective remain unencumbered. Traditional securities lending, in this sense, is just one element of a far wider collateral motivation and strategy.”
Challenges ahead
Upcoming challenges for Germany’s securities finance space this year and 2020 include the effects of Brexit and SFTR. As well as this, Kazimi points out that recent comments by Germany’s finance minister, Olaf Scholz, report significant progress made on the plans to introduce a financial transaction tax (FTT) in European Union countries that support the project, including Germany. While the precise scope of FTT is being determined, there is a risk that this may have an impact on liquidity.
Fran Garritt, director of securities lending and market risk of the Risk Managament Association, commented: “Germany will face the same challenges from a regulatory perspective as all of the EU markets, including SFTR, which is a major effort on behalf of the industry and not specific to Germany, and the great unknown that is Brexit.”
He notes that for the German market specifically, “it will be interesting to watch how the news around a possible merger between Deutsche Bank and Commerzbank takes shape over the course of 2019, and also how BaFin’s unprecedented ban on new shorts in Wirecard works out. There has been a lot of coverage on this already, with possible legal action against the BaFin being suggested”.
“Brexit will impact markets across Europe as businesses may have to be done out of entities located on the continent, thus banks and broker/dealers will have to change their operating structure. However, efforts to ensure market activity is not disrupted have been ongoing.”
Lara Fries, principal consultant at Capco, Germany, emphasises that without a doubt, SFTR is the biggest challenge facing the industry in Germany. She explains that the reuse of securities to increase liquidity induces complex transfers between traditional and shadow banks which might jeopardise financial market stability, and the regulation intends to mitigate this risk.
Fries says: “This will demand increased transparency around complex securities financing transactions to identify counterparties and monitor the concentration of risk. There will also be an obligation for market participants to report information on securities financing transactions to an EU-wide acknowledged trade repository (TR). That might be the same as the European Markets Infrastructure Regulation TR, but Brexit may mean that it becomes necessary to report to two different TRs.”
“The biggest challenges next to SFTR will be Brexit. Trading behaviours will have to change as the UK transitions to third country status upon exiting the EU; it remains to be seen how regulatory equivalence will be achieved if indeed it is at all. Preparations to address the major transformational challenge posed by the planned late 2021 transition from interbank offered rates (IBORs)—most famously LIBOR and Euribor—to new risk-free benchmark rates will also prove burdensome for firms.”
Additionally, Dyson says that as we look at 2019 and into 2020 more broader, issues prevail in both Germany and the rest of Europe where the lack of securities lending specials on the back of low levels of fundamental alternative investment activity, is limiting lending opportunities.
He adds: “Brexit in isolation, whatever form or timescale should not impact the German market specifically, although the potential loss of access to London market liquidity could affect this and other continental European securities lending markets.”
Heath argues that the same challenges presented by SFTR are also its biggest opportunity if the industry can solve for them.
He suggests: “SFTR is providing a stimulus towards greater automation than ever before. In recent history, a major portion of the lending industry’s technology budget has been taken up by regulation, which could be argued has been at the expense of innovation and take up of wider automation.”
“However, with SFTR, there is a notable move towards leveraging key technology partners to increase levels of on-venue trading, post-trade matching and reconciliation providers as well as looking at standardisation of data and options to centralise reporting through vendor partners. SFTR and CSDR are regulatory pressures that could move the market to automate and innovate where it has previously been slow to adapt. This is clearly a positive consequence of what will undoubtedly be challenging regulatory reporting requirements.”
Opportunities on the horizon
In terms of the opportunities that GITA could bring, Kazimi remarks: “The biggest game changer would be the EU Capital Markets Union. The drive towards harmonised EU markets will require liquidity to be injected into the market, and the best way to do this is for the removal of market impediments.”
“The other big opportunity lies in the technological possibility of blockchain. At present on account of the successive tax measures, the ‘baby has been thrown with the bath water’. Perfectly legitimate trades have been removed from lending programmes on account of having to satisfy onerous beneficial ownership requirements.”
Riesack also believes that technology could provide opportunities for Germany for the next five years, he comments: “Looking forward, digitalisation obviously comes to mind. We recently saw the first securities token offering (STO) in Germany, and this may have an effect down the road for securities financing markets: namely, with more STOs emerging, how do you lend or repo tokens? Also, can DLT/blockchain technology serve to ease or enhance overall end-to-end processing? Introducing robotic process automation to streamline processes may be a good first step forward.” But Riesack notes that this is not too dissimilar from the other main investment markets across Europe.
However, Dyson adds: “Set against the backdrop of a lack of both volatility and fundamental activity in the equities markets, opportunities in the German market look limited at this point in time.”
