Time for a rethink?
23 July 2019
David Lewis of FIS discusses the dip in the securities finance industry’s global revenues and explains the factors changing the dynamics of the industry
Image: Shutterstock
2018 was a good year for the securities finance industry, with global revenues of $10 billion coming from record balances and activity. Unfortunately, sometimes there is only one way to go when you are at the top, and that is down. 2019 has not started well, at least in comparison to 2018, with volumes dropping through the first quarter and revenues down around 10 percent in the second compared with recent years. But is this just the industry taking a breather before pushing further upward, or could it be a sign of something more fundamental?
With half my career spent as an agent lender, the mantra that you cannot create demand to borrow securities, only make yourself an attractive lenders has never been more appropriate. Borrowing demand is certainly down, and there are potentially many reasons for this. In Europe, the fall of the yield enhancement (or dividend arbitrage to give it its old, pre-health and safety name) trade will have had a dramatic impact, but there are also other forces at work. Regulatory issues are being blamed by some, as the demands and costs of compliance with Securities Finance Transaction Regulation (SFTR, coming into effect in April 2020) and risks of settlement fines from Central Securities Depository Regulation (CSDR), for example, push those on the periphery of the market to leave.
However, these effects, should they come about, will affect the supply side of the market more than the demand side. At present, a lack of supply is not the problem—quite the opposite in fact, so looking to repeal or reduce regulation is not the answer. Supply in the market has increased substantially over recent years as more funds look to securities lending to increase returns and/or mitigate their costs, such as those exchange-traded funds (ETF) providers and asset managers launching zero management fee funds. The simple laws of supply and demand dictate that this increase, in and of itself, will lead to a slimming of the slice of the revenue pie for individual funds, if not a reduction in the total pie overall.
The gross revenue across the market is, instead, falling from a lack of demand, which the beneficial owners and their agents are relatively powerless to change. Part of that change can be blamed on the characteristics of the lending market driving demand away, and some on the change in the profile and behaviours of the end user, hedge funds and alternative asset managers. A bias towards long positions is arguably a cyclical effect; there may be other, less cyclical and more systemic changes at play, combining to reduce borrowing demands.
A move to synthetics is one argument, with hedge funds looking to other trade structures that might offer the same economic results, but some of these still rely on someone in the chain borrowing or lending the underlying security as a hedge, therefore exposing the counterparties to the changing borrowing costs, and therein lies the rub. At FIS, our engagement with hedge funds and alternative asset managers, as some prefer to be called, has increased dramatically over recent years. It is often said that a measure of your own age is how young police officers look; in the finance industry it seems to me that should be just as applicable to hedge fund managers, some of whom have never worn a tie, or perhaps even long-sleeved shirts. Something else that appears foreign to them is the reliance of relationships when it comes to trading.
Many systemic or quantitative funds have no traders at all; the job description simply doesn’t exist. A machine, working on parameters and data feeds, transacts with the market; such machines care little for relationships and they are not something that can be factored into the decision process. The analysts and quants driving such strategies struggle with the idea that a transaction they made yesterday to borrow a security at 1 percent, might cost them 10 percent today. With, say, a six-month trade in mind, they are driven to look for economic certainty to feed their models.
The securities lending markets struggle to cope with this demand, in certain circumstances at least, driving the end users to look elsewhere. The need to re-rate is understandable; the agents are employed to make the most revenue they can for their lending clients, but the prime brokers also need to be paid for their credit intermediation, so rate hikes get passed on. The requirement for a solution has driven innovation in peer-to-peer lending and enhanced custody offerings, employing a provider’s own assets, or looking across their own client base rather than borrowing from ‘the street,’ which, of course, brings the net borrowing demand down across the traditional transaction chain.
In this respect, it may be possible to point the finger at regulations. The second Markets in Financial Instruments Directive has driven the search for ‘best execution’ across many markets, and the requirement to prove that transactions have been undertaken at the best possible rate has certainly impacted the securities finance market. Unfortunately, one aspect of this has been the reliance on a simple measure of what best execution really means. In many markets, where a trade is enacted, it is simply the strike price, evidenced as being at the published ‘market rate,’ whereas a securities finance transaction lasting weeks or months is not so easily measured. Applying the best rate as a benchmark drives all parties to re-rate up and down as the market moves, but, as discussed above, this may be part of why demand is falling. Lower net revenues for beneficial owners cannot be construed by any observer as best execution, particularly as some funds which need lending revenues to pay their management fees may well lend under the market to secure those revenues, bringing a whole new layer of best execution conflicts into play.
Automation of our market, with advanced matching of borrowers’ needs to lenders’ capacities, will help maintain returns as efficiencies rise and costs fall. But this is not the whole story or the long-term answer; in the medium to long term, the structure of the market will need to change, moving to meet the changing demands of its end users, or accepting those changes and changing direction away to a more insular collateral management exchange-driven business. Whatever the outcome, there are multiple factors at work changing the dynamics of our industry—factors that require complex solutions and a capacity for change.
With half my career spent as an agent lender, the mantra that you cannot create demand to borrow securities, only make yourself an attractive lenders has never been more appropriate. Borrowing demand is certainly down, and there are potentially many reasons for this. In Europe, the fall of the yield enhancement (or dividend arbitrage to give it its old, pre-health and safety name) trade will have had a dramatic impact, but there are also other forces at work. Regulatory issues are being blamed by some, as the demands and costs of compliance with Securities Finance Transaction Regulation (SFTR, coming into effect in April 2020) and risks of settlement fines from Central Securities Depository Regulation (CSDR), for example, push those on the periphery of the market to leave.
However, these effects, should they come about, will affect the supply side of the market more than the demand side. At present, a lack of supply is not the problem—quite the opposite in fact, so looking to repeal or reduce regulation is not the answer. Supply in the market has increased substantially over recent years as more funds look to securities lending to increase returns and/or mitigate their costs, such as those exchange-traded funds (ETF) providers and asset managers launching zero management fee funds. The simple laws of supply and demand dictate that this increase, in and of itself, will lead to a slimming of the slice of the revenue pie for individual funds, if not a reduction in the total pie overall.
The gross revenue across the market is, instead, falling from a lack of demand, which the beneficial owners and their agents are relatively powerless to change. Part of that change can be blamed on the characteristics of the lending market driving demand away, and some on the change in the profile and behaviours of the end user, hedge funds and alternative asset managers. A bias towards long positions is arguably a cyclical effect; there may be other, less cyclical and more systemic changes at play, combining to reduce borrowing demands.
A move to synthetics is one argument, with hedge funds looking to other trade structures that might offer the same economic results, but some of these still rely on someone in the chain borrowing or lending the underlying security as a hedge, therefore exposing the counterparties to the changing borrowing costs, and therein lies the rub. At FIS, our engagement with hedge funds and alternative asset managers, as some prefer to be called, has increased dramatically over recent years. It is often said that a measure of your own age is how young police officers look; in the finance industry it seems to me that should be just as applicable to hedge fund managers, some of whom have never worn a tie, or perhaps even long-sleeved shirts. Something else that appears foreign to them is the reliance of relationships when it comes to trading.
Many systemic or quantitative funds have no traders at all; the job description simply doesn’t exist. A machine, working on parameters and data feeds, transacts with the market; such machines care little for relationships and they are not something that can be factored into the decision process. The analysts and quants driving such strategies struggle with the idea that a transaction they made yesterday to borrow a security at 1 percent, might cost them 10 percent today. With, say, a six-month trade in mind, they are driven to look for economic certainty to feed their models.
The securities lending markets struggle to cope with this demand, in certain circumstances at least, driving the end users to look elsewhere. The need to re-rate is understandable; the agents are employed to make the most revenue they can for their lending clients, but the prime brokers also need to be paid for their credit intermediation, so rate hikes get passed on. The requirement for a solution has driven innovation in peer-to-peer lending and enhanced custody offerings, employing a provider’s own assets, or looking across their own client base rather than borrowing from ‘the street,’ which, of course, brings the net borrowing demand down across the traditional transaction chain.
In this respect, it may be possible to point the finger at regulations. The second Markets in Financial Instruments Directive has driven the search for ‘best execution’ across many markets, and the requirement to prove that transactions have been undertaken at the best possible rate has certainly impacted the securities finance market. Unfortunately, one aspect of this has been the reliance on a simple measure of what best execution really means. In many markets, where a trade is enacted, it is simply the strike price, evidenced as being at the published ‘market rate,’ whereas a securities finance transaction lasting weeks or months is not so easily measured. Applying the best rate as a benchmark drives all parties to re-rate up and down as the market moves, but, as discussed above, this may be part of why demand is falling. Lower net revenues for beneficial owners cannot be construed by any observer as best execution, particularly as some funds which need lending revenues to pay their management fees may well lend under the market to secure those revenues, bringing a whole new layer of best execution conflicts into play.
Automation of our market, with advanced matching of borrowers’ needs to lenders’ capacities, will help maintain returns as efficiencies rise and costs fall. But this is not the whole story or the long-term answer; in the medium to long term, the structure of the market will need to change, moving to meet the changing demands of its end users, or accepting those changes and changing direction away to a more insular collateral management exchange-driven business. Whatever the outcome, there are multiple factors at work changing the dynamics of our industry—factors that require complex solutions and a capacity for change.
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