US lending specialists draw lessons from COVID and the GameStop short squeeze, discuss the demands of sustainable lending and highlight where lenders can drill into new opportunities moving into 2022
Panellists
Justin Aldridge
Senior vice president, head of agency lending
Fidelity Investments
Mark Coker
Head of North America equity agency trading, securities finance
Northern Trust
George Rennick
Head of agency securities finance – Americas and global head of client relationship management in agency securities finance, J.P. Morgan
Vikas Nigam
Director, Head of Agency Securities Lending for the Americas
Deutsche Bank
Tom Ryan
Head of asset-liability trading, global securities lending solutions group
Mitsubishi UFJ Trust & Banking Corporation
Martin Tell
Senior managing director, global head of securities finance, State Street Global Markets
How do you assess the performance of US securities lending markets during 2021 to date? What trends have you noted in terms of loan balances and lending fees? What have been the high earners — and the weak performers?
Justin Aldridge: The year began with one of the largest and highest-impact short squeezes the markets have seen. This had a wide-ranging effect, causing muted demand for fundamental single-stock shorting as short sellers retrenched to strategise about the new dynamic of crowd trading, with investors targeting companies with high short interest.
IPOs and special-purpose acquisition company (SPAC) IPOs have been key market drivers as well. Special situation opportunities like mergers and tenders have been down this year, compared to previous years, resulting in a negative impact on lenders’ overall earnings, but there are a few large opportunities on the calendar for Q4 of this year. We have seen strong demand for US fixed income issues and clients have been able to realise significant revenues on multiple “on the run” issues. The markets have been resilient and earnings appear to be on target overall to match or slightly exceed last year’s North American totals.
Mark Coker: US equity securities lending balances have risen through 2021, predominantly due to mark-to-market adjustments as equity markets continued to rally. This market dynamic, supported by Fed stimulus and lower interest rates, has resulted in a softer specials space. The rise of retail trading groups has also added borrower caution on highly shorted securities. High earners have generally come from new issuances (IPO/SPACs) or the exchanged-traded fund (ETF) sector.
Strong performance in the US fixed income securities lending space has come with the flight to quality and renewed demand for high-quality liquid assets. Loan balances increased in 2021 relative to the previous year, in part due to the abundance of US dollar cash in the market. We have seen a general increase in lending spreads, driven in large part by lower rebate rates on loans versus cash collateral and demand for benchmark securities.
George Rennick: On a year-over-year comparative basis, 2021 is underperforming 2020, mostly due to an abundance of US dollar cash in the financial system, spread compression and a lack of specials. Loan balances have increased across all asset classes, but relatively speaking fees have been compressed, with the exception of a handful of specific securities. SPACs, ETFs and specific IPO and deal-name securities have offered high returns. Cash re-investment yields and general collateral securities have been challenged.
Vikas Nigam: 2021 has been another interesting year from a securities lending perspective. Though not quite as dramatic as the 30 per cent plus stock market drop of Q1 2020 and subsequent recovery, early 2021 saw securities lending make mainstream news headlines as hedge funds were caught in massive short squeezes in popular meme stocks like Gamestop and AMC – all the while allowing clients holding these securities to enjoy bumper revenue.
As with 2020, Q2 onwards has been a different story. With stock markets continuing to rise and an ever increasing amount of cash being made available at the short end, spreads have continued to be squeezed at both ends, with revenue only being up year-on-year from increased balances derived from higher valuations and increased high-quality liquid asset (HQLA) activity. With a number of state treasurers and public pension plans as clients, we have also seen the effects of the American rescue plan, with billions of dollars added to lendable assets. We anticipate this will be repeated if the infrastructure bill is passed.
From the broker-dealer perspective, we have seen shifts in borrowing and funding needs to mirror the reflation trade (go long equities and short fixed income), with broker-dealers taking advantage of excess demand for their business to address regulatory requirements like extending duration and shifting balances to net stable funding ratio (NSFR)-friendly clients.
Martin Tell: Overall, as always, there have been bright spots and challenges. Two challenges I would note were: the contraction of specials trading after the GameStop and Reddit stocks’ short squeezes as short sellers de-risked and assessed their positioning to deal with both a new and determined equity investor base; and renewed interest in oversight of short sellers and other market participants.
The continued low-rate environment is also a challenge for fixed income lending as well as cash reinvestment. The bright side has been that, despite a period of de-levering, there has been a resurgence of directional specials activity in IPOs, SPACs and, as a general statement, small cap securities have garnered good interest from borrowers through the summer.
Which regulatory projects will have the greatest impact on your lending programme over the 12 months ahead? What adaptation challenges will these present?
Rennick: Over the next 12 months, certain European based regulations such as the Central Securities Depository Regulation (“CSDR”) will garner focus and support. Adherence to global banking capital rules will also have maximum impact as entities remain focused on balance sheet management and optimisation.
Coker: The most poignant of topics is CSDR, which introduces new measures for the authorisation and supervision of EU Central Security Depositories (CSDs) and sets out to create a common set of prudential, organisational, and conduct of business standards at a European level. CSDR applies to all European CSDs and to all market operators in the context of securities settlement — which will need to directly comply with the measures the regulation introduces related to mandatory buy-in regime and cash penalties for settlement failures. Therefore, the scope of the regulation also includes, and impacts, US and Canadian clients and borrowers that trade European securities (equities and fixed income). It will be particularly important for agent lenders to have strong operational foundations, such as those present at Northern Trust with our global custody business coupled with a robust procedural control ecosystem to successfully navigate CSDR penalty regimes.
Tell: Speaking specifically for the US, we continue to digest changes that have occurred over the past few years as proposed regulation becomes law. For our institution, like all banks, these changes will increase the financial resource burden of most types of financing activity. The shared challenge is to become increasingly efficient with those resources, which may include further access to CCPs, alterations to how indemnification is applied, growth of facilitated peer-to-peer transactions and use of new technologies to both strengthen and grow our programme into the future.
The Q4 19 repo spike in the US was followed in early 2020 by the COVID-19 crisis. How did the market react? What lessons (if any) did you learn from this period that you will carry forward?
Rennick: During the repo spike of 2019 and the initial US lockdown period of the COVID-19 crisis (March 2020), the markets encountered an acute drain on liquidity as US dollar cash was hoarded and excess cash was trapped. In securities lending, liquidity buffers muted impact but raising necessary cash was expensive. The traditional lending and borrowing of securities functioned normally, with a higher percentage of securities on loan being collateralised with non-cash collateral. Cash collateral yields fluctuated throughout the two events, but opportunities did exist, especially with the volatility in rates. However, as an agent, it was important to ensure that cash reinvestment trading was commensurate with individual client risk tolerances and, in most cases, conservative portfolio management was the desired approach.
Tom Ryan: Both events spurred volatility, not just in the securities lending arena but in the broader markets as a whole. Therefore, as our team dealt with the implications of the disruptions, our beneficial owners were also dealing with their own situations. As such, the impact to revenue generation was less important to any risks and exposures, with both incidents leading to refresher courses on safeguards inside their securities lending programmes, counterparty credit quality, and the finer points regarding indemnifications.
In the aftermath of the Q4 19 repo spike and the reduction of the Federal Reserve reducing rates, from a range of 1.50 – 1.75 per cent to near zero in under two weeks, market participants were reminded that interest rate gap (i.e. mismatch) risk was something to be mindful of. The previous years had witnessed rate movements, both up and down, but in small increments of 25 basis points and generally signalled clearly in advance. As a programme, we clearly understand that securities lending will not always be at the top of a client’s priority list during a crisis period and that it is up to us to steer them through all market conditions.
On the other hand, amid these challenges lay opportunities for agent lenders to assist beneficial owners with regard to their overall liquidity profiles. With equity markets in dramatic decline and other internal liquidity pressures at hand, some beneficial owners were reminded that, in consultation with their agent lender, they could draw on their securities lending collateral pool. Clients with this construct written into their contracts would have been further advanced along the learning curve and in a better position to employ that option. Any beneficial owner that had this conversation with their agent lender — or conversations regarding perceived or actual risks inherent in their securities lending programme — came out of the March 2020 market turmoil stronger than they went into it.
As the effects of COVID-19 began to take hold, it was clear that certain industries were going to be dramatically affected. These industries were encapsulated in an acronym fancifully named BEACH, which stands for Booking, Entertainment, Airlines, Cruises, and Hotels. Although at some points it looked as though some constituents of these categories would be unable to survive the pandemic, the reversal of their situations, and subsequent stock and bond prices, mirrored the broader market, albeit in a typically lagging fashion. Securities lending spreads and associated revenues for these categories followed suit.
Aldridge: Fortunately, neither event had a negative impact on our securities lending agency programme. Fidelity was well positioned to take on additional business, given our highly automated trading platform, our clients’ conservative investment strategies and our ability to stay the course through volatility. It was business as usual and, in fact, Fidelity’s securities lending programme benefited from the dislocation. Our on-loan cash balances increased significantly during this time.
Coker: The repo spike in late 2019, and the Federal Reserve response to the COVID crisis in March and April of 2020, both relate to the same market function – the level of excess reserves. What was a deficit of reserves in 2019, which increased rates, now dominates the story line as a surplus of reserves which is depressing yields.
Demand in fixed income was characterised by a flight-to-quality bid, with market participants looking to source HQLA, particularly in term maturity exposures versus lower-rated or less-liquid collateral. In the credit space, initial demand for corporate bonds was correlated with those industries most exposed to the COVID-19 impact such as leisure, travel, retail, and autos. Markets quickly calmed through the second quarter, with central bank actions providing comfort to market participants to re-engage across markets and trade structures.
Several hedge funds lost substantial sums on GameStop and other meme stocks in the early part of 2021 as retail investors battled with hedge funds that held short-interest positions in those securities. Some agent lenders indicated that this short squeeze triggered de-leveraging as hedge funds sold off long positions to cover losses and closed out shorts owing to contagion fears.
How (if at all) will these events change behaviour in US lending markets?
Tell: The challenge it presented was one that, frankly, we think we were well prepared for — and that is one of strong risk management. Market volatility caused by these events can have an impact on client lending appetite, counterparty and collateral exposures, and impacts on lending returns in terms of revenue. A zero-rate environment is challenging for client reinvestment. I would not say it is illiquid — we have no issues locating product to invest in, but with low rates and a flat yield curve the economics of general collateral trading change. We adjust our loan pricing and overall volumes of general collateral to ensure that we generate a return on those loans that are aligned with our clients’ expectations.
Generally speaking, the only impact was to revenue as specials trading contracted and demand decreased. Clients certainly wanted to speak about the topic, as it was a headline item each day, but we didn’t see any behavioural or mandate changes on the back of this.
Short sellers will be more cognisant of this new type of herd mentality and will be more thoughtful in the companies they trade. Even if the fundamentals indicate a security is overvalued, they may stay on the side-lines. We may also see few crowded shorts that drive the short interest in a stock to levels that garner attention. This could lead to a greater number of securities having demand, but at lower levels with fewer deep specials and more names in the warm space.
Rennick: Gamestop and other meme stocks did have an impact on hedge fund performance, portfolio construction and behaviour, both short and long term. Initially, short interest among crowded names subsided quickly as hedge funds reduced exposure. Single name demand and special balances decreased for a period of time, as trading against momentum increases risk. After a few weeks, demand rotated to certain sectors, but hedge funds remain cautious. Longer term, more hedge funds will factor in short interest in the decision-making process, as well as social media signals. Potentially uncorrelated, but during the period and throughout most of 2021, ETFs have experienced a significant jump in demand. In fact, demand for ETFs is increasing annually. Perhaps the diversification of using an ETF as a hedge helps offset the short squeeze of a single name, in vogue stock.
Ryan: The securities lending and financing industry is dominated by the laws of supply and demand. Were we to list out the actions, events, and sentiments that can shape these factors in securities lending and finance, this would be a long list. However, the GameStop short squeeze and subsequent debilitating losses by hedge funds have perhaps changed the paradigm. Agent lender rate changes (following the traditional supply and demand playbook) were at times met with strong resistance — with the reasoning being that their clients had “lost enough” on the trade. Albeit indirect, any linkage between a shorts performance and ability to enact a rate change alters the supply and demand calculation.
Aldridge: Overall, the securities lending markets worked as they should and no lenders or agents were directly affected by this activity as far as we are aware. This definitely had a negative impact on demand to borrow securities with high short interest and fees.
Immediately after the events, the US equity specials market was nearly cut in half from a market value perspective and average fees charged dropped dramatically. We think the market for super specials with high short interest remains at risk in the near term. This will have long-term effects for short sellers as they grapple with managing their short investment ideas and the potential risk of falling victim to a short squeeze orchestrated by a crowd of investors. In some cases, we are seeing investors utilise exchange-traded funds (ETFs) to effect their short views, instead of using a single security to reduce short squeeze risk.
What are the key issues for the US securities lending community in promoting high ESG standards across the SLB transaction value chain? How will this impact the range of assets included in the lending programme? And screening of collateral?
Aldridge: One of the key issues is that clients need more timely, valuable data that can help them make the best decisions for their investors, particularly relating to proxy voting. We could potentially see temporary reductions in availability as we get closer to some proxy record dates if more investors begin to recall. We could also potentially see a reduction in availability of some securities as clients eliminate investments in companies that do not meet their ESG standards. Both phenomena have the potential to drive fees higher for those names.
Clients also need the flexibility to modify collateral schedules, without minor changes drastically affecting their returns. Improved technology and automation will be needed in many cases to manage these new standards effectively. Fidelity has deep expertise with ESG investing and we have been focused on it for many years.
Tell: The rest of 2021 will most likely be a continuation of what we have seen in Q3, with low rates overall and a reasonable volume of specials activity in the same theme we have seen so far this year. There may be some volatility as we once again debate our debt ceiling and spending plans, along with messaging from the Fed about the beginnings of tapering off quantitative easing. These could also have some impact into 2022, if over time we begin to lift away from the very low rate environment and have greater opportunities due to widening spreads.
We continue to invest heavily into our technology development and that will be the theme for 2022, not only to enhance our trading capabilities within the existing securities finance platform but also in partnership with other areas of the firm to broaden our collateral, risk management and digital capabilities. Clients are looking for ever more complex and intertwined product offerings. This requires investment of time and resources in multiple businesses to deliver.
Ryan: ESG is becoming more predominant as beneficial owners establish their own policies and stances. We strongly believe that securities lending activities can co-exist happily with the ESG philosophies and approaches of our clients, and that a client’s ESG objectives can be factored into a securities lending programme without creating unmanageable conflicts or undue concerns. Each agent lender has built up their ESG “tool-kit” to be overlaid to their clients.
With ESG being so important to MUFG and our programme, we have established a global head of ESG dedicated to securities lending. This person is working with our clients to understand their needs and requirements and with our product development teams to implement policies, procedures and solutions. We are also working in close cooperation with all industry associations to help frame the market discussion.
It remains crucial that we engage upfront with institutional asset holders to explain where conflicts may, occasionally, be identified and how they can be mitigated. Understanding a client’s objectives and creating a bespoke programme for clients has always been a cornerstone of our product offering. The current focus on ESG has not changed our philosophy in that respect.
Coker: Recent Industry surveys have shown that ESG principles and securities lending can co-exist, so the range of assets used within the securities lending program is not typically impacted by ESG. The challenge to the lending agent is to ensure it can support clients’ needs by ensuring the lending activity is aligned with their corporate objectives. Transparency around short-selling, borrowing practices and recall policies is being supported by the introduction of regulation in some regions (such as SFTR). Proxy voting on behalf of the beneficial owner, with the ability to recall ahead of meetings, is key alongside the ability to restrict and screen collateral based upon clients’ ESG needs. This extends to cash collateral reinvestment.
There is a need for refinement around ESG to ensure the continued efficiency of securities lending — for example, adding pressure to secure more timely disclosure of proxy information by companies (to fully support the timing of the recall) and providing clear definition of ESG parameters, which will assist with the creation of standardised ESG collateral sets.
Whilst we focus on the challenges, there are also opportunities within securities lending. For example, the recent issuance of green bonds has created new revenue opportunities via an improved ‘greenium’ (the premium on green bond prices). This is currently a watch item as we see how demand evolves.
Nigam: ESG is a major topic for Deutsche Bank and a key focus across the bank, so it is a topic we are quite familiar with. Whereas some clients have historically implemented a form of ESG by limiting investments and collateral holdings of so called ‘sin’ stocks (for example, tobacco, gambling, alcohol, defence), it has taken until now for ESG to become more mainstream — with the topic now being discussed across our entire client base, particularly in Europe.
That said, the biggest challenge is the lack of a common framework regarding what ESG means and what it should look like. As more indices are created and adopted by investment managers and tri-party providers, ESG requirements and compliance should become more second nature. Until then, we are having to work with clients and counterparties to implement bespoke rules with appropriate compliance monitoring.
Rennick: Securities lending has long supported individual client ESG standards, the most common nexus often identified as governance around proxy voting policies and eligible collateral schedules. In the US, ESG tends to focus on portfolio construction and security selection, away from securities lending. As ESG continues to evolve and elevate in importance and evolve, so too will the securities lending industry. Recently, the Global Framework for ESG and Securities Lending (GFESL) has been developed in partnership by the Pan Asia Securities Lending Association (PASLA), Risk Management Association (RMA), International Securities Lending Association (ISLA) and endorsed by the Canadian Securities Lending Association (CASLA) to meet the need for a globally consistent approach. These are the largest associations representing the securities lending industry and they recognise the broad umbrella of ESG lacks consistency. Therefore, their collaboration sets an ambitious framework for standardisation at the intersection of ESG and securities lending.
How do you assess the outlook for US securities lending markets into 2022 and what is top of your development priorities as a securities lending team?
Nigam: For the most part, we see markets treading water as participants look for resolutions or additional guidance on the big macroeconomic items that are currently dominating the agenda – namely the debt ceiling, Fed tapering, the size and extent of the infrastructure bill and, of course, the inflation and interest rate outlook. All of these should see some progress and clarification over the next few months. As differences between expectations and realities take shape, we should see increased volatility leading to additional borrowing and funding activity.
In the meantime, we expect additional inflows into money market funds, especially with the Fed announcing a doubling of their Reverse Repo Program (RRP) counterparty limit to US$160bn per day. Given the extent of excess cash in the system and our primary focus on using government money funds and non-traditional repo as cash investments, Deutsche Bank has been investing heavily in our automated securities lending (ASL) platform. We have also been building our capability to accommodate additional client segments, looking for lightweight and low risk ways of generating incremental returns on their excess balances.
Rennick: Pockets of opportunity exist for the remainder of 2021 and 2022. In the US, Q4 offers macro events including US Federal Reserve tapering, or tapering discussions, US debt ceiling debates, challenges to reopening the economy and potentially two significantly sized stimulus packages ($900mm and $3.5T) that would be funded with significant tax policy changes.
Aldridge: We remain very optimistic about our clients and their securities lending returns going forward. The market and the industry have proven very resilient throughout the COVID crisis, the low interest rate environment and the meme stock frenzy. In 2022, we expect returns to normalise back to 2018-2019 levels, with potentially higher interest rates and increased demand to borrow.
Our top development priorities continue to centre on enhancing our clients’ experience through technology and strengthening their connectivity with their custodian and their borrowers, while improving their returns. At Fidelity, we will continue to enhance our automated trading platform, and provide access to our ESG tools and our unique benchmarking and transparency solutions to help clients with their investment decisions. Across the enterprise, Fidelity invests heavily in technology and security and we have more than 20 years of experience in all aspects of securities lending.
