What did the 2020 lockdown puppy-rush and securities lending have in common, and what lessons can be learned heading into a new year?
Looking back at 2020 is a position many have been looking forward to, based mostly on the belief that just being in a different year would be enough to make a difference. There is, indeed, much about 2020 that should be consigned to the rubbish bin and perhaps forgotten as quickly as possible, but there are also many lessons to be learned.
Some simple rules will never change
Where demand exceeds supply, prices will rise. This maxim proved itself both in the access to hot stocks in times of market stress as much as it did in toilet roll and puppies. Lockdown has had several curious effects on the people that experienced it and, in the UK at least, that impacted the price of dogs. The seemingly obvious response to spending more time at home for many was to get a dog, which resulted in the average price of a new puppy in the UK doubling to £1,875, with the jump in prices largely resulting from the very slow response to the change in demand.
Puppies weren’t all that changed. With the market volatility that affected the first few months of 2020, there was a frenzy of activity around the shares of companies exposed to the full force of the lockdown and its effects on travel, leisure and retail spending, at least in the case of brick-and-mortar retailers. The plummeting valuations of many such companies attracted strong borrowing activity and, therefore, strong revenues for securities lenders as well as those enabling the transactions.
Lendable inventory across 2020, especially in equities, was up compared with 2019. With levels of demand remaining relatively static, outside of regional and asset class variations, the unavoidable result was a reduction in the overall fees earned. At the time of writing, incomes are beginning to recover with November showing an improvement and the outlook for the rest of December trending positive.
So, in contrast to the UK puppy market, excess supply meeting stagnant demand has meant that as lendable supply increased, so average borrowing rates declined.
The market is changing
While it is logical to say that the quite astonishing bull run we have witnessed in many stock markets will have had short sellers sitting on their hands, limiting exposure to rising share prices and not borrowing shares to short, this may not be the only thing that is affecting demand in the securities finance market. Rising asset prices benefit lenders and their service providers. Looking back across the end of 2020, the S&P 500 rose some 65 percent across the nine months from March. Over the same period, the Euro Stoxx 600 increased by 37 percent. It follows that the higher the value of loan, the more to charge a fee or rebate against.
But just like short selling profit calculations, it all depends where you start from. While those indices have recorded significant gains, they do not have the same net outcome. At the time of writing, the Euro Stoxx 600 was down a net 2 percent on the year and 10 percent below its 12-month peak. For the S&P, it is up some 18 percent on the year, which perhaps says more about benign government policy and the arrival of numerous vaccines than true market values, but the impact on lending revenues will be positive, particularly when combined with the very low yields on US treasuries.
With rising asset prices providing some relief for stagnating demand, will 2021 be better for securities lending than 2020? That might be a yes, but only if one or both of the following occur:
Firstly, the demand side of the market must stay the same in nature. Those wishing to take a negative view of the price of an asset must return to the securities finance market and the existing transaction chain to facilitate that position. To do this, they have to ignore the growth in options, contracts for difference and other mechanisms to create advantages when asset prices fall. If they are looking to create a short position in the traditional manner, they must advise their broker not to internalise that trade and instead seek supply from the traditional channels, and be sure to avoid any peer-to-peer platforms that seek to streamline the traditional transaction chain.
Secondly, the bubbles in stock markets need to risk a burst, attracting short sellers back to the market and increasing the demand to borrow shares. With many indices at record highs, particularly in Asia where, for example, the South Korean KOSPI is at an all-time high (and, incidentally, where short selling is currently banned), there is arguably ample room for a correction which may bring a bonanza for lenders and short sellers. But may not – see the previous point.
Change is vital for success
Making sense of the changes happening to and around the securities finance market is vital if it is to adapt to the pressures placed upon it. There are a number of bright lights on the horizon, such as new markets opening up or expanding their operations in securities finance, including the Middle East, China and India. New markets bring optimism and new vigour – and, of course, attractive fee levels compared with more mature markets. Further, the final phases of the Uncleared Margin Rules will bring further demands for collateral to smooth and secure the way other parts of the financial market operates. There is also a great deal of effort being put into improving market automation and efficiency, which is the logical response to a market with pressures on revenues and costs. Increased automation will allow for more efficient transactions at the point of trade, lower maintenance and failure costs, and improved — or at least protected — margins.
A bursting stock market cannot be relied on for revenue projections in 2021, particularly given the optimism of economic recovery that the arrival of effective vaccines appears to be bringing, but the other headwinds and challenges that the market faces in the ‘new normal’ must be addressed. With the speed of change increasing, time to meet market demands will be vital. To take too long will miss the opportunities presented. No one wants to be left offering new puppies just when everyone has gone back to work.
