Time for term
25 July 2017
Balance sheet regulations are increasing the attractiveness of longer term trades, allowing some lenders to cash in. Simon Colvin of IHS Markit explains
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Balance sheet regulations have pushed an increasing number of market participants to ‘term out’ a greater portion of their securities lending transactions for longer periods of time, which offers an opportunity for lenders who can facilitate this trade.
Lending out government bonds has been one of the few industry bright spots of the past 12 months. While the rest of the securities lending industry has suffered from a general lack of demand and weak pricing power, government bonds have enjoyed a strong 20 percent increase in revenue over the first half of the year.
This bumper revenue haul is largely driven by two factors, derivatives clearing rules that are forcing financial market participants to source ever growing amounts of high-quality collateral to post to central counterparties, and increasingly stringent balance sheet regulations which are forcing banks to lock in funding for even longer periods of time.
The latter of these two factors has not only increased the demand for high-quality government bonds, it has also led to market participants lending out an increasingly large proportion of the asset class through term loans. Terming out government bonds has been especially popular since the liquidity coverage ratio (LCR) framework set out by the Basel III rules came into effect in 2015.
The regulation looks to ensure that banks hold sufficient amounts of high-quality liquid assets to meet expected outflows for specific periods of time. Government bonds, which have the lowest LCR weighting, have registered a material increase in the proportion of the asset class trading term over the past few years. This increase means that 36 percent of all government bonds now out on loan are lent through term transactions versus the 22 percent registered 10 years ago, before Basel III first came to light.
Demand for term has been a global trend as the three main most liquid government bond types, UK gilts, US treasuries and bonds issued by European Central Bank (ECB) member states, have all registered material increases in the proportion of their securities lent on a term basis. US treasuries are currently the most likely to trade term as fully 45 percent of the $470 billion of treasuries now out on loan in the securities lending market are lent on a term basis.
Length of term
Volumes paint only half the picture, however, as our data indicates that investors have been terming out trades for increasingly longer periods of time over the past few years, a trend which is particularly prevalent in Europe.
LCR implementation saw the value weighted length of term trades made out for bonds issued by ECB member states jump from 150 to 370 days while UK gilts term trades grew from 277 to 334 days. LCR implementation was a large driving force behind this trend as its initial implementation in 2015 heralded the biggest jump in the length of European term transactions.
The US market was the one exception to the rule as value weighted length of term treasury trades has remained roughly flat over the past five years around the 90-day mark.
Fee premium
On top of pledging to borrow term trades for increasingly long periods of time, IHS Markit data indicates that European bond borrowers are willing to pay an increasingly large premium to borrow on a term basis since LCR’s initial implementation back in January 2015. ECB member bonds and gilt term trades commanded a 5 basis points (bps) premium to open trades back in December of 2014. That number has since jumped to 8 bps for ECB bonds and a massive 14 bps for UK gilts.
While not every securities lending participant is able to facilitate term trading, the revenue stream for those that can is unlikely to dry up anytime soon given that the four-year gradual LCR implementation still has some room to run until its full implementation in 2019. Further regulatory tailwinds may also be in the offing for term eligible lenders as the net stable funding ratio regulations seem poised to further drive the demand for secure supplies of high-quality liquid assets over the coming years.
Lending out government bonds has been one of the few industry bright spots of the past 12 months. While the rest of the securities lending industry has suffered from a general lack of demand and weak pricing power, government bonds have enjoyed a strong 20 percent increase in revenue over the first half of the year.
This bumper revenue haul is largely driven by two factors, derivatives clearing rules that are forcing financial market participants to source ever growing amounts of high-quality collateral to post to central counterparties, and increasingly stringent balance sheet regulations which are forcing banks to lock in funding for even longer periods of time.
The latter of these two factors has not only increased the demand for high-quality government bonds, it has also led to market participants lending out an increasingly large proportion of the asset class through term loans. Terming out government bonds has been especially popular since the liquidity coverage ratio (LCR) framework set out by the Basel III rules came into effect in 2015.
The regulation looks to ensure that banks hold sufficient amounts of high-quality liquid assets to meet expected outflows for specific periods of time. Government bonds, which have the lowest LCR weighting, have registered a material increase in the proportion of the asset class trading term over the past few years. This increase means that 36 percent of all government bonds now out on loan are lent through term transactions versus the 22 percent registered 10 years ago, before Basel III first came to light.
Demand for term has been a global trend as the three main most liquid government bond types, UK gilts, US treasuries and bonds issued by European Central Bank (ECB) member states, have all registered material increases in the proportion of their securities lent on a term basis. US treasuries are currently the most likely to trade term as fully 45 percent of the $470 billion of treasuries now out on loan in the securities lending market are lent on a term basis.
Length of term
Volumes paint only half the picture, however, as our data indicates that investors have been terming out trades for increasingly longer periods of time over the past few years, a trend which is particularly prevalent in Europe.
LCR implementation saw the value weighted length of term trades made out for bonds issued by ECB member states jump from 150 to 370 days while UK gilts term trades grew from 277 to 334 days. LCR implementation was a large driving force behind this trend as its initial implementation in 2015 heralded the biggest jump in the length of European term transactions.
The US market was the one exception to the rule as value weighted length of term treasury trades has remained roughly flat over the past five years around the 90-day mark.
Fee premium
On top of pledging to borrow term trades for increasingly long periods of time, IHS Markit data indicates that European bond borrowers are willing to pay an increasingly large premium to borrow on a term basis since LCR’s initial implementation back in January 2015. ECB member bonds and gilt term trades commanded a 5 basis points (bps) premium to open trades back in December of 2014. That number has since jumped to 8 bps for ECB bonds and a massive 14 bps for UK gilts.
While not every securities lending participant is able to facilitate term trading, the revenue stream for those that can is unlikely to dry up anytime soon given that the four-year gradual LCR implementation still has some room to run until its full implementation in 2019. Further regulatory tailwinds may also be in the offing for term eligible lenders as the net stable funding ratio regulations seem poised to further drive the demand for secure supplies of high-quality liquid assets over the coming years.
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