US-based securities lending specialists focus on recent market performance, projections for 2023, and the potential impact of further Fed tightening on trading and collateralisation strategies
Panellists
Justin Aldridge
Head of Agency Lending, Fidelity Investments
Michael Cardieri
Executive Director, Head of the Agency Securities Finance (ASF) Americas Equity Desk, J.P. Morgan
Mark Coker
Head of North America Equity Agency, Northern Trust
Joe Gillingwater
Head of Fixed Income Agency Trading, Northern Trust
Michael Saunders
Americas Head of Agency Securities Lending, Securities Services, BNP Paribas
How do you assess the performance of US securities lending markets during 2022 to date? What trends do you identify in terms of loan supply, borrower demand and loan revenue?
Joe Gillingwater: Fixed income lending continues to provide robust revenue amid heightened demand across asset classes. US treasuries remain well sought after, given the regulatory environment, while volatility in the curve led to some special opportunities. Moreover, diverging central bank policies have provided significant cross-currency arbitrage opportunities, with borrowing counterparts increasingly keen to use JGBs as collateral at wider fees than is typical.
Another standout performer through the securities finance lens has been the credit markets, with rising interest rates leading to increased funding costs at a time of recessionary fears. As such, we have seen fees for corporate bond loans continue to widen dramatically amid robust borrow demand.
Mark Coker: From a US equity perspective, volumes throughout the period have been volatile as the ebb and flow of the equity markets impacted borrower needs and collateral availability. We have seen a general risk-off stance, or de-grossing, from investors with GC volumes softening as a result.
In late Q2, we saw a noticeable improvement in ‘specials’ spreads translating into strong revenue across the equity book. In large part, the Russell Reconstitution was the catalyst, with changes in supply triggering increased lending spreads on already highly-shorted names. The reconstitution also saw the addition of several companies which were originally created through special purpose acquisitions in 2021, some trading at heightened fees.
Exchange-traded Funds (ETFs) have been a strong source of demand this year, especially those with exposure to corporate bond, US equity and China indices, given the Fed tightening, market volatility and China economic slowdown.
Michael Cardieri: The US securities lending market performance has been very strong in 2022 against the backdrop of inflation at a 40-year high, the war in Ukraine, supply chain issues, COVID-19 lockdowns in China and higher interest rates. Following the worst first half of the year for the US equity market since 1970, there was a significant increase in demand for single stock names, particularly in the consumer discretionary sector, electric vehicle (EV) space and meme names. Revenue from IPO lockup trades remained robust at the start of the year owing to a record setting year for IPOs in 2021. ETF lending has been strong, specifically high yield and investment grade corporate bond ETFs and index ETFs, owing to the rising interest rate environment and market volatility.
Michael Saunders: The dramatic increase in market volatility so far in 2022 has presented opportunities and challenges. Slowing global growth, stubborn inflation and coordinated central bank tightening have created an environment for lenders to monetise portfolios of high-quality liquid assets (HQLA). The knock-on impact of the market volatility has reduced the number of IPOs, which has reduced intrinsic lending opportunities, especially compared to 2021. Lendable supply, or rather industry participation from institutions, continues to increase, driven by increased participation and engagement from beneficial owners seeking to increase revenue streams.
Justin Aldridge: So far, 2022 has been a banner year for our lending programme clients for revenue and utilisation, despite limited IPO issuances and limited merger arbitrage deals. The volatility in the markets, coupled with rising interest rates, has brought single stock shorting to the forefront of lending activity. Our lending revenue is up nearly 100 per cent and our balances are up approximately 25 per cent year-on-year. We believe our clients are benefiting from our automated lending technology and our positioning in the marketplace as a non-bank entity without Risk Weighted Assets (RWA) and Single Credit Counterparty Limits (SCCL) hampering our ability to service our clients effectively.
S&P Global Market Intelligence reports that equity specials balances have rebounded strongly during 2022, with the top 10 revenue-generating equities in the US market accounting for more than 30 per cent of the entire lending revenues for the region for H1 2022. What are the drivers and what opportunities does this create?
Aldridge: The key driver, single stock shorting, has returned after its hiatus following the meme stock frenzy in 2021. Alternative asset managers are seeing more opportunities on the short side, given the increased volatility in the market coupled with rising interest rates. On the negative side, we expect that the limited IPO issuances during the first half of 2022 will continue to hamper revenue opportunities in the second half of this year.
Saunders: Revenues attributed to specials is certainly a game of have and have nots. Beneficial owners holding any number of the assets in the “Top 10” experienced relevant, and in some cases substantial outperformance relative to the market return. Institutions not holding these ‘specials’ focused on a more sustainable long-term strategy of lending general collateral, opting for a stable and predictable revenue stream to offset administrative expenses.
Cardieri: The key drivers are inflation and the Fed’s reaction to inflation. With hindsight, the Fed was behind the curve with regard to inflation after flooding the market with liquidity during the pandemic. The result pushed inflation to 40-year highs. The Fed adopted a hawkish stance in early 2022, moving interest rates aggressively. More rate hikes are expected in the coming months. In anticipation of continued rate increases and easy money drying up, short-selling broadened out across asset classes, names and sectors.
What impact is the current US macroeconomic climate, particularly the prospect of further Fed tightening, having on the outlook for lending markets?
Saunders: The coordinated tightening campaign from central banks globally has triggered historic levels of volatility. This volatility has led to a fair amount of opportunities for beneficial owners. Asset owners and asset managers have shifted to lending all asset classes in their portfolios as the higher federal funds rates have influenced all asset classes from high yield, sovereign lending, to ETFs, through to growth and value equities. The Federal Reserve’s actions to increase federal funds from 250bps to 350bps through September 2022 has presented substantial opportunities, certainly when lending US Treasuries. The ability to engage in duration-mismatched lending programmes in a rising rate environment has proven to be impactful from a revenue generation perspective. This strategy continues to benefit those willing to manage the liquidity risk of lending on a short-term basis and reinvesting cash collateral into longer dated tenors. This will continue until the FOMC ceases its tightening campaign.
Cardieri: There is the camp that believes the Fed will engineer a soft landing, no recession or a shallow recession, resulting in risk-on sentiment and a view that buyers will return. A continued strong job market and short covering will provide additional fuel to the rally. This view could drive refinancing and a narrower list of specials. An offset to this would be that companies will move forward with IPOs which will provide lending opportunities first when the IPO goes public and then around the lockup expiration date. Deal activity should pick up under better market conditions, which will also provide lending opportunities.
There is another camp that believes the Fed is too late in responding and now being too aggressive in its fight against inflation. The economy will fall into a deeper recession and short sellers will establish or increase short positions as the job market softens, consumer spending slows and corporate profits decline. Highly leveraged companies will have trouble refinancing debt and credit conditions will deteriorate, resulting in rating downgrades and increased demand in the corporate bond market. Quantitative tightening may limit US Treasury supply, resulting in increased specials to meet capital adequacy and liquidity needs. IPOs will remain on the sidelines and deal activity will remain muted.
Gillingwater: The Federal Reserve’s recognition of the inflationary environment towards the end of 2021 provided some strong opportunities across the securities finance programme. There was greater focus on cash reinvestment portfolios, with the frequency and size of rate hikes having to be closely managed in the asset-liability complex. Additionally, the emergence of yield opportunities in sovereign curves has prompted some challenges across credit and emerging markets. With the two-year Treasury yielding 3.50 per cent, there is pressure on riskier assets, particularly with recessionary concerns on the horizon.
As mentioned previously, diverging interest policies, and the removal of high-quality sovereign bonds held by The Bank of Russia, have prompted wider fees when lending dollar-denominated assets versus cross-currency sovereign bonds. Therefore, lenders have taken the opportunity to pivot away from equities and corporate bonds as collateral, instead preferring the safety of European sovereign bonds, UK gilts and Japanese government bonds (JGBs) for example.
Coker: I would add that risk appetite, generally, is in short supply, given the uncertainty with selling pressure across the equity indices. Directional demand across the equity book has pivoted to names with swelling debt obligations, with rising interest rates or inflationary pressures impacting their supply or raw material costs. The fintech, consumer discretionary, retail and real estate sectors have all seen heightened borrower demand, which is likely to continue.
Aldridge: It has a tremendous impact on the lending markets. As we stated in Securities Finance Times Issue 288 in October 2021, we were very optimistic that 2022 would be a banner year for lending revenue, given that rising interest rates would negatively impact companies’ earnings and create more opportunities on the short side. The reinvestment market remains challenging, but will provide more opportunities once the Fed’s policy initiatives have stabilised inflation.
How are these trends shaping collateralisation strategy?
Cardieri: Owing to the market volatility, borrowers are experiencing a collateral shortage and this is translating into difficulty in adding new borrows and filling existing trades. Cash collateral has remained strong during the past year, bucking the historical trend of an increase in non-cash collateral. There has also been an increase in loan refinancing activity. As borrowers look for collateralisation efficiency, there is strong demand to collateralise loans with ADRs, ETFs, corporate bonds, convertible bonds and special-purpose acquisition companies (SPACs).
Gillingwater: The cadence and size of the Fed’s rate hikes during 2022 have provided both opportunities and challenges. Lending rebates reset immediately after the rate increase, while a cash reinvestment portfolio with a duration mismatch and blended Weighted Average Maturity (WAM) of 60 days obviously takes a while longer to catch up. As such, investment managers have sought shorter maturities for much of the year, with floating rate instruments and repo typically preferred over term bullet investments. Fed policy will likely become clearer in the coming weeks and months as we reach the terminal funds rate. At this time, lenders are likely to look to increase the allocation of loans versus cash.
Saunders: Cash lending in a rising rate environment presents the greatest optionality relative to non-cash collateral lending, all else being equal. Implementing a duration mismatch lending and cash reinvestment strategy captures the forward monetary policy actions of the Federal Reserve, where beneficial owners can monetise the anticipated rate hikes on the cash collateral portion of the transaction while realising the lower funding cost when raising liquidity on an open or shorter-duration tenor.
Aldridge: The Fidelity Agency Lending programme is currently focused on US ‘40 Act asset managers who are limited to accepting cash and US government securities for non-cash collateral. In general, prime brokers are significantly less interested in providing US government securities as collateral, and their preference is to post equities. Equity collateral is not a permitted collateral type for borrowers to post to US banks and ‘40 Acts. We estimate that US asset managers have seen non-cash balances decline by roughly 30 per cent over the last 12 months on average, and this only represents a small portion of all outstanding loans in the market for this client type. We continue to expect muted demand to provide US government securities as collateral while the Federal Reserve raises interest rates and shrinks their balance sheet. If the SEC were to amend rule 15c3-3 to allow US borrowers to deliver equities as collateral and amend the ‘40 Act to allow US mutual funds to accept equities as collateral, then we would anticipate significant growth in non-cash flow for US mutual funds in the future.
Where is technology innovation most reshaping US lending markets during 2022? Where are you focusing your technology and innovation budget to deliver better lending outcomes?
Aldridge: We will continue to focus on improving our programme through our artificial intelligence (AI)-powered automated-lending technology to maintain our status as a first destination for borrowers’ needs. At Fidelity, we are continuously enhancing our reporting and data distribution technologies to ensure we can meet our clients’ evolving data needs. We are also focused on expanding our collateral flexibility for existing clients. A lot of time and effort is being applied to transparency and optimisation tools that help clients maximise their returns. Our team is also doing some unique work on qualified dividend income (QDI) optimisation for firms that view this as a binding constraint for their lending programmes.
Saunders: Innovation and technology are key pillars to a successful securities lending programme from an efficiency, cost and execution perspective. Both technology and innovation are paramount to programme growth. Transparency and data reporting, both internally and externally, remain our focus.
At BNP Paribas, our focus is on a mix of vendor-based and proprietary technologies to best meet our clients’ needs and enhance the quality of our offering even further.
Cardieri: J.P. Morgan Agency Securities Finance (JPM ASF) is committed to providing an outstanding client experience and has allocated significant technology resources to be a leader in the industry. We continue to enhance our proprietary web-based portal, providing complete transparency to a client’s programme offering performance, analytics and governance. Examples include a visualisation of the client’s programme parameters and a “What-If” tool to capture opportunity costs and forecast possibilities.
In support of the ESG agenda, JPM ASF has sourced external vendor proxy event data to identify upcoming events of interest for a client’s portfolio assets. Clients have the capability to establish rules to restrict positions from being lent over event dates based on prescribed event information, including meeting types and other criteria. JPM ASF will expand on its pay-to-hold offering, rolling out a US pay-to-hold product in Q4. Automation is critical to distribution. To increase straight through processing (STP) flow, JPM ASF continues to invest and improve pricing models and the use of in-house developed AI to refine offer rates in our proprietary trading system. In short, technology remains a core component of our growth strategy.
In November, the Securities and Exchange Commission proposed Exchange Act Rule 10c-1, which would require lenders of securities to provide the material terms of securities lending transactions to a registered national securities association, such as the Financial Industry Regulatory Authority.
How do you react to this initiative? What refinements to the 10c-1 proposal may be required to make this work effectively for the US securities lending market?
Cardieri: JPM ASF contributed to the industry feedback through the Securities Lending Committee of the Risk Management Association (RMA) comment letter. As a firm, JPM has also provided feedback through the Securities Industry and Financial Markets Association (SIFMA) and other industry and regulatory meetings. To be clear, we are supportive of increased transparency, but with the suggested proposals outlined in the RMA comment letter. Some of the refinements highlighted in the comment letter centre around the timing of the reporting, the reporting of securities available to loan, the party responsible for the reporting, the scope of the reporting, the public dissemination of data, and the flexibility in the production of Unique Transaction Identifiers. The European markets were deemed to have been successful with the implementation of SFTR. A logical outcome of 10c-1 would be to leverage the SFTR model for its best parts and consistency.
Saunders: As a global lender with clients in almost every major market, the introduction of SEC 10c-1 is manageable. Similar to SFTR, the bank has the resources to implement the SEC proposal. We are fortunate in this regard. Entities, either banks or counterparties, who historically have focused their activity on the US market exclusively will experience several growing pains in implementing SEC 10c-1. Transparency is a positive development for the industry. However, specific elements of SEC 10c-1, namely the disclosure of available supply as a reporting field, has the potential to cause unnecessary levels of information sharing.
More broadly, which regulatory projects will have the greatest impact on your lending programme over the 12 months ahead?
Saunders: There are two critical pieces of legislation slated to be discussed, and potentially finalised, by the SEC in the near future. SEC 2a-7 Money Market Reform and SEC 10c-1 are manageable, but will distract businesses from enhancing their offering to the benefit of their clients, instead requiring that they focus time, energy and resources on implementing the SEC proposals.
Aldridge: We do not believe that any of the pending regulatory changes will have a significant impact on our lending programme. We have built a securities lending programme that is flexible and able to provide real-time data to clients and regulators as requirements change. Fidelity also actively comments on proposals to help shape regulation and would plan to lead with technological solutions for any new requirements. Consequently, we believe we can adapt quickly to any new requirements.
The proposed rule 13f-2 could have a negative impact on the lending returns of beneficial owners. Alternative managers could react to the additional transparency requirements by reducing the amount of single stock shorting they engage in, owing to the heightened risk of coordinated short squeezes with the additional information in the market. This would reduce income generated for shareholders of funds that participate in lending.
In a recent SFT feature, we debated the value of securities lending indemnification, noting that the capital cost borne by the agent in providing indemnification may often far exceed the economic benefit realised by the lender. Are lenders likely to explore alternative lending options beyond an indemnified lending programme?
Aldridge: This topic has been discussed many times over the last decade, as capital costs for agent lenders have risen due to changes in regulation. We have seen very few clients move to un-indemnified programmes during this time. The returns, in general, are probably not significant enough for a beneficial owner to take on the counterparty risk, even as remote as the losses might be. Therefore, I would expect that other changes would need to occur to see a material segment of beneficial owners actively participate in un-indemnified lending.
Cardieri: Prior to the financial crisis, indemnification on the lending side became the norm. Post the financial crisis, and the ensuing implementation of the governing capital rules and financial metrics, the cost of providing indemnification has become too expensive and it is on an unsustainable path in its current form. This is particularly the case when we consider the lower fee splits retained by the agent banks and the true benefit, or lack thereof, that the indemnification provides. Not all indemnification products are equal and not all are backed by fortress balance sheets, but it is also true that indemnification can reasonably be viewed as an expensive over-insurance policy. Lenders and agents are looking towards, and currently implementing, alternatives inclusive of expanding non-indemnified programmes, peer-to-peer lending, altering pricing and collateral models. Central counterparty clearing (CCPs) is also being explored, but with a cautionary focus on cost allocations.
Saunders: Indemnification is an interesting topic for several reasons. The over-collateralisation of trades and daily margin collateralisation can be viewed as an adequate risk protection mechanism, deeming indemnification unnecessary. However, as a leading global lending agent and custodian, our client base gives a high degree of importance to indemnification. Given the option to receive indemnification from a lending agent or not, I cannot think of a scenario where a lender would choose not to be indemnified. Therefore, it becomes a commercial decision to offer indemnification or not to clients.
There continues to be elevated discussions between agents and borrowers on reducing the over-collateralisation, especially on collateral transformation transactions involving sovereign debt. In the event that lenders agree to reduced collateralisation, I would anticipate that indemnification will become more important and prevalent.
How do you assess the outlook for US securities lending markets for the remainder of 2022 and into 2023? What is top of your development priorities for this period as a securities lending team?
Saunders: The remainder of 2022 and first half of 2023 will continue to experience elevated volatility. Slowing growth, higher rates and stubborn inflation will remain the focal point for market participants. The combination of these factors will inevitably present opportunities, especially when lending specific assets which have high degrees of interest rate sensitivity.
Gillingwater: The outlook remains healthy. Several factors continue to drive the demand for US treasuries: dollar premium in currency markets, regulatory factors including Uncleared Margin Rules and the Liquidity Coverage Ratio, along with the inflation backdrop, which may perpetuate hawkish policy and fuel specials activity. In addition, global macroeconomic challenges will preserve demand for perceived riskier assets as valuations remain challenged. As always, we are very aware of market liquidity challenges so adequate buffers, and potentially excluding a growing number of corporate bonds from lending availability, will be prudent risk management tools. Lastly, collateral mobility will be key, particularly if signs of bond scarcity move to US markets. As such, clients should employ a full suite of collateral options, allowing them to make quick decisions regarding the best use of their assets.
Northern Trust has continued to invest heavily in our technology, with a focus on automation, flexibility and enabling our clients to make the best possible data-driven decisions for their portfolios across trade construction, execution, and lifecycle management.
Aldridge: All else being equal, we believe the second half of 2022 will not be as profitable for US lenders as the first half of 2022 unless deal and IPO activity picks up. We are optimistic that 2023 will potentially be a great year for lenders as the markets normalise from aggressive rate hikes, and we see a normalised funnel of new IPOs coming to the market along with a healthy amount of deal activity. We do expect volatility to continue, given global tensions and the elevated possibility of a recession.
Cardieri: We anticipate that demand for single stock names will remain strong during the final months of 2022, but not as strong as earlier in the year.
The lack of IPO activity in H1 2021 will almost eliminate the IPO lockup expiration opportunity. IPOs will return if market volatility decreases — with the pipeline potentially including Mobileye, VinFast, Reddit, Instacart, Stripe, Discord and ServiceTitan.
Specifically, the deal activity pipeline with lending opportunities remains quiet. However, borrowers continue to source low RWA supply for general collateral supply to provide balance sheet relief.
Looking forward to 2023, if the Fed achieves a soft landing this is likely to weaken demand for single stock names but will contribute to a rebound in IPO and deal activity. In contrast, if the Fed engineers a hard landing, there will be strong demand for single stock names and IPO and deal activity will remain muted.
