As the second largest securities lending market in APAC, Hong Kong has been the success story in recent times and industry experts are seeing continued growth for clients there
Standout performer
Branded as the “standout market” in Asia in recent times, Hong Kong is seeing continued growth for clients lending securities. There has been an increase in specials activity across Asia Pacific (APAC) which has contributed to strong lending returns. This story of growth rests against the backdrop of an uncertain external environment with the ongoing China and US trade war, yet experts say they expect to see the Japanese market continue to thrive.
Commenting on the current state of Hong Kong’s securities lending industry, Andrew Geggus, head of securities lending trading, Asia Pacific, Northern Trust, says: “Hong Kong has a well-developed securities lending framework, and as the second largest securities lending market in Asia Pacific, Hong Kong continues to serve as an important revenue source for clients.”
“Bolstered by the significant end-user demand for exposure to China, Hong Kong is a clear destination for investors with its comparatively deep liquidity profile. In the absence of a viable means to transact securities lending via the Stock Connect, we see this trend continuing for the near future.”
Geggus continues: “The number of clients lending Hong Kong securities continues to grow in line with the global expansion of securities lending interest; while the number of local clients lending either domestic or global assets remains relatively small. We anticipate this changing in time with familiarity and the need for return.”
Zubair Nizami, vice president, head of Asian securities lending trading, Brown Brothers Harriman, also observes an increase in specials activity across Asia Pacific and explains that this growth can be attributed to several factors, such as high asset values, robust borrower demand, increased beneficial owner participation in lending programmes and strong corporate deal flows.
Nizami comments: “While Asian markets overall generated strong lending returns, we have certainly seen Hong Kong as one of the stand-out markets in recent times. However, we have witnessed a softening in securities lending demand across the region since the beginning of the second quarter of 2019, with Hong Kong particularly impacted.”
“A slowdown in corporate deal activity, coupled with an uncertain macro environment, largely due to the escalation in the China/US trade war, has resulted in reduced hedge fund activity and consequently subdued borrowing demand. Given an uncertain external environment, we expect lending returns in the region to reflect this trend in the second half of 2019.”
Japan’s thriving market
Japan’s securities finance market has continued to thrive for a variety of reasons, and Nizami explains that abenomics and, more specifically, the loose monetary policy set by the Bank of Japan (BOJ) has driven key Japanese interest rates into negative territory for a prolonged period.
He states: “As a result, Japanese banks looking for foreign currency funding have been actively engaging in financing transactions, thereby boosting overall volumes. In addition, this has enabled foreign banks and brokers to be active in placing their surplus Japanese yen or assets to Japanese counterparts that accept this form of collateral.”
There has also been a healthy demand for specials in the past few years spurred on by strong corporate deal activity and an increased focus on corporate governance for Japanese-listed companies by activist investors, Nizami highlights.
Nizami cites: “Finally, Japan has an established securities finance framework which has less rigid rules and regulations compared to other markets in the Asia-Pacific region, and a deep pool of liquidity in both equities and fixed income.”
“This provides investors with the confidence to actively participate in the market. The lower barriers to entry for new entrants is also a major factor in encouraging both foreign and domestic participation, thereby boosting overall market liquidity and returns for investors.”
Hong Kong trends
Global trends emerging across the broader beneficial owner community are also applicable to beneficial owners in Hong Kong. Geggus points out that the drive to maximise performance in a low yielding market environment is helping to grow momentum in new clients entering the securities lending space, or clients that previously participated re-entering.
He stipulates: “Securities lending is increasingly being looked at as an integrated investment vehicle to complement the suite of front-office activities in pursuit of meeting performance objectives. In this regard, beneficial owners are looking for ways to ensure their securities lending programmes are being optimised within a prescribed level of risk tolerance, which is keeping agent lenders focused on investment in innovation and technology. This is markedly different to the days of securities lending sitting in the back-office as an engine to merely offset costs. We see this trend continuing.”
He continues: “That said, the distinction between outbound securities lending (Hong Kong-based clients lending local and global assets) and inbound lending (non-domestic clients lending Hong Kong assets) is pronounced.”
Geggus further noted that inbound lending is a mature and well-developed practice, whereas outbound lending by domestic beneficial owners and intermediaries is some way behind much of the Asia Pacific and the global industry.
According to Geggus, this trend is expected to change in time as potential lenders become more familiar with the benefits of a robust and well-managed securities lending programme and start to enter (or re-enter) the market, seeking return and cost offset.
Nizami adds: “We are seeing several trends from our global clients with an overarching theme focused on generating additional revenue from securities lending to augment their investment activity.”
“In Japan, institutional clients remain focused on meaningful returns, as securities lending returns are an important revenue generator in the current environment. Additionally, a relatively new development in Japan is the rise of actively managed equity mandates in lending programmes.”
“In the past there has been a misconception in the market that only passively managed global index mandates would be suitable for lending. However, because of increased engagement with active managers about the benefits of lending we have been able to advance this discussion, which is an overall positive for boosting liquidity and generating returns for investors.”
Incorporating ESG
Globally, environmental, social and governance (ESG) investing in the securities finance industry is becoming more prevalent. Recently, the Stock Exchange of Hong Kong published an ESG consultation paper to support and improve issuer’s governance disclosure of ESG activities and metrics.
The consultation, a ‘Review of the Environmental, Social and Governance Reporting Guide and related Listing Rules’, suggested that introducing mandatory disclosure requirements in the reporting guide should include a board statement setting out the board’s consideration of ESG issues.
It was noted that it should also include applications of relevant reporting principles and boundaries in the ESG report. Further key proposals included requiring disclosure of significant climate-related issues which have impacted and may impact the issuer, and amending the ‘environmental’ key performance indicators to require disclosure of relevant targets.
Geggus noted that Northern Trust created customisable solutions for clients that help them to manage their requirements including the incorporation of ESG practices.
He adds: “Incorporating ESG is not without its challenges for the securities lending industry, as one of the common factors of ESG programmes is the requirement for securities to be available for voting. This requires a robust process being in place to ensure all securities that are out on loan are recalled ahead of key voting dates, ensuring the voting rights remain with the underlying client. This can cause a reduction in liquidity and stability for borrowers over certain key dates, which needs to be a consideration when managing their securities borrowing programmes.”
Hong Kong’s horizon
Despite seeing areas of growth and cause for optimism, there are challenges that Hong Kong will face over the next 12 months. Nizami comments: “From a demand perspective, we believe a further escalation in the China/US trade war, continued uncertainty in the Eurozone economy and geopolitical risk factors such as Brexit and escalating tensions in the Middle East may lead to significant challenges for the capital markets. As we have seen in the second quarter of 2019, this market uncertainty has started to reflect on reduced returns for the securities finance industry.”
Nizami also explains that aside from the macro environment, the implementation of the Securities Finance Transactions Regulation in 2020 will continue to remain a major focus for the industry. A successful roll-out to ensure securities finance data can be reported to trade repositories by the stated deadline will be of paramount importance for market participants.
Geggus remarks: “As the securities lending industry rapidly evolves, it is not without challenges. The industry continues to demand reduced latency in execution and improved efficiency, and balance sheet is a scarce commodity. However, these challenges have provided multiple opportunities.”
He says: “Firstly, the advances in technological capabilities continue to transform not only the securities lending industry in Hong Kong but across the broader financial markets globally.”
“Outside of technology, we see the development of capitally efficient routes to market as a key opportunity for the industry as the borrower community continues to look for ways to reduce their capital footprint and optimise the scarcity of available balance sheet. As such, there continues to be a focus on regulatory efficient structures such as collateral pledge model, which is beginning to grow as a more regularly utilised route to market. The pledge model not only allows for the potential reduction in cost of capital for borrowers, but also potentially allows for increased spreads and haircut for lenders able to subscribe to the framework.”
Looking to the future, Nizami predicts: “In the long-term we would expect to see the Hong Kong securities market become more integrated with mainland China. However, the big question on the minds of many market participants is ‘when will China open its securities lending market for foreign investors?’ In our view, while the potential will be a game changer, we believe that we are quite some time away from an established and robust securities lending framework, that can compete with the likes of Hong Kong, Japan or South Korea.”
Nizami concludes: “However, the desire to do so is certainly there and the recent engagement between the relevant exchanges, regulators and industry associations has been positive.”
