Securities finance specialists reflect on macro events which have impacted the sector over the past 12 months, the opportunities this has created in European markets and where firms are investing to enhance their lending activities
Panellists
Grant Mansfield, director, head of trading, EMEA fixed income, equities and cash collateral investment, BNY Mellon
Danila Khanh Dinh, trading associate, Agency Securities Finance, J.P. Morgan
Dayna Chamberlain, trading associate, Agency Securities Finance, J.P. Morgan
Mark Jones, senior vice president, head of securities finance, EMEA, Northern Trust
Christian Schuetze, head of financing solutions, Europe, State Street
How do you assess the performance of European securities lending markets over the past 12 months?
Dayna Chamberlain: Market volatility has been a key determinant of the securities lending landscape. The series of macro events caused by the Russia-Ukraine war triggered a cost-of living crisis and fears of recession, which was worsened by the successive interest rate hikes implemented to combat rising inflation. These mounting macroeconomic pressures shifted short interest towards cyclical sectors with names predominantly within the consumer discretionary, real estate and banking sectors. Sovereigns also experienced a surge in demand as a result of the gilt crisis, which triggered tightening in the credit markets and a drain on collateral liquidity.
As we entered 2023, we saw a general reduction in revenue opportunities across equities as hedge funds became more conservative in their positioning, with the size and breadth of specials decreasing as markets recovered. We saw spreads widen across the credit market as a result of increased activity from systematic hedge funds, with liquidity taking a more prominent role in pricing to better reflect the risk profile of assets. Q2 2023 saw cost of capital and high expenditures begin to weigh heavily on balance sheets and, as such, we saw pockets of corporate action activity within distressed sectors as companies looked to raise cash to weather a potential recession.
Christian Schuetze: The last 12 months were once again characterised by a change in trade structures and goals. Our perception is that while demand for high-quality liquid assets (HQLA) remains unbroken, maturities continue to move from liquidity coverage ratio (LCR) to net stable funding ratio (NSFR) coverage. On the equity side, we see more stocks that are warm or special. The levels and, ultimately, the fee income are at a higher level.
Grant Mansfield: Quantitative easing has caused a compromise in supply for bunds and gilts, equating to increased utilisation and spread. In the corporate and emerging market space there has been a continuation of volatility and, therefore, spread has been present for more than two years due to various factors including Brexit, Covid, energy inflation due to the war in Ukraine, and the recent banking crisis. This led to sector-related interest in the equity markets. European indices witnessed heavy volatility and a large flight to quality, resulting in a need for collateral as equity sell offs left counterparts needing to cover their collateral obligations through securities lending.
In which European markets (by jurisdiction, asset class) do you identify strongest opportunities for growth of your lending business?
Mark Jones: We have witnessed significant growth in lending volumes and fees for US corporate bonds and dollar-denominated emerging market debt. With the Federal Reserve reaching the terminal rate, we would expect some greater traction in European credit markets as the European Central Bank (ECB) looks set to maintain interest rate hikes to combat inflation. Global recessionary fears should also start to emerge, driving greater activity in credit markets as corporate bond issuers are forced to endure higher funding costs.
Added caution on long bias strategies has reduced internalisation opportunities, increasing the need for borrows and driving demand for supply. Furthermore, interest rate hikes have had a bearing on swap pricing, impacting the demand dynamic.
Schuetze: Although I don’t have a crystal ball, I am convinced that we will continue to see high levels of volatility in the markets. Accordingly, trends change too quickly and you have to remain mentally flexible enough to be able to change course if necessary. HQLA will remain a central topic. I also expect strong impacts from the clearing obligation for pension funds.
Mansfield: With quantitative tightening having started, it is tempting to say that the spread due to illiquidity in gilts, and to a lesser degree in bunds, will disappear. But that will depend on the rate of tightening and the behaviour of the national debt management agencies. Well rated HQLA, if not special due to liquidity factors, can be used in term and cross-currency swaps to create spread. Despite the macroeconomic landscape proving difficult, the need for cap raising or expansion should re-establish itself. Firms still have a desperate need to raise capital to cover rising costs and we should see an increase in capital raisings from distressed firms, as well as the need to fund takeovers and growth, given that borrowing cash is now a lot more expensive. A direct correlation should see increased activity in the M&A space, with firms primed for takeover due to being cash strapped and hampered by debt.
Chamberlain: Over the coming year, there may be a bigger focus on macro and credit strategies, with hedge funds gaining short exposure via broader asset classes in lieu of traditional equity shorting as firms struggle to refinance their debt from historical low levels. While this presents an opportunity for increased utilisation across those asset classes, lack of transparency within the OTC market brings liquidity and settlement challenges.
The introduction of alternative supply pools also presents a potential opportunity for considerable growth, with non-traditional funds and the evolution of lending models within emerging markets, such as the Middle East, being our focus for 2023. The lack of established lending supply pushes fees higher than those seen in developed markets and, with the facilitation of short selling likely to increase trading volumes, demand for securities can be expected to grow.
Digitalisation also brings potential opportunities to mobilise non-traditional asset classes and markets, alongside a possible expansion of the assets accepted for collateral purposes, with tokenisation becoming a key concept.
Global financial markets have faced one of the most financially tumultuous periods entering 2023 since the end of the global financial crisis. What pressures and opportunities has this created for your securities lending business?
Danila Khanh Dinh: The past couple of years have been an exciting time for securities lending, experiencing fast-paced hikes since 2020, bond future volatility and collateral scarcity, then compounded with Russian invasion, a gilt crisis due to the UK mini budget in September 2022, Silicon Valley Bank events and the contagion into European banking assets. Credit markets have seen liquidity of collateral dry up. This has presented challenges across the industry as a result, with infrastructure strained as market participants adapt to handle the volumes of new trades and recalls. The start of this year saw a softening in the specials book as rallying indices generated an unwind across many sectors. We have seen credit and macro strategies direct flow away from equity into credit to gain exposure to companies, and firms that are set up to support cross asset trading, with dynamic pricing and liquidity models and a strong automation foundation, have been able to adapt to these changes successfully.
Schuetze: Daily credit oversight and counterparty risk are two things our clients frequently ask us about, and their concerns are understandable. Thanks to our rigorous monitoring processes, paired with our more than 40 years of experience in managing lending programmes, neither of them had been an issue to us at State Street.
The real challenge lies in the current interest rate environment. Most loan programmes have a borrower default indemnification. The spread between value and price widens massively in the increasing yield environment, making indemnifications very expensive.
At the same time, however, we also see significant opportunities. These lie in both the lending and repo business. We were the first major custodian to become a Eurex Repo Clearing member earlier this year, which will help boost our liquidity tool kit and provide a full financing product suite to customers of the bank.
Mansfield: HQLA spreads and utilisation have increased with macro-economic changes — central bank easing has compromised supply in certain markets and interest rate rises create an environment that is healthy for certain counterparties to take positions. With a natural spread in bonds, the need to term trades diminishes and a book can stay shorter. In the credit markets, the Ukraine war and the banking crisis have simply added more volatility to a market that was already active. As we moved further into the year, with more confidence in equity markets, we have witnessed a return in activity and risk appetite. Despite the collapse of Credit Suisse and the banking sector initially being brought into question with concerns surrounding some of Europe’s global systemically-important banks (GSIBs), strong statements from European leaders, as well as stronger capital reserves, brought the sector quickly back in line.
What impact has monetary tightening had over the past 6-12 months on lending opportunities and collateralisation strategy in Europe?
Mansfield: Tightening is something that is going to take spread out of some HQLA assets, specifically gilts and to a lesser extent bunds. Liquidity in bunds has been increasing for some time, but, in gilts, where supply is still compromised, tightening will have an effect, although the plan for £80 billion in 12 months is not aggressive. Monetary tightening, coupled with inflationary pressure fuelling recessionary fears leading to a market sell off in equities, brought about an increased need to borrow non-cash collateral. However, with a return in the yield curve, opportunities present themselves to capture additional spreads achieved from terming up cash collateral.
Jones: We remain highly-focused on counterparty risk. As such, we have taken action during the period, utilising multiple different measures to protect our clients from the headwinds noted. With market stress comes potential opportunity. Therefore, our trading desks have taken advantage of wider lending fees, while continuing to transact with the highest-rated counterparts in the market. A general risk-off sentiment across the hedge fund community has created a de-grossing cycle with borrower balances softening somewhat. Specials demand has been more concentrated with macro environment concerns acting as the primary driver. Those companies most exposed to servicing high levels of debt in the midst of increased borrowing costs attract the strongest interest. The greater market volatility and investor uncertainty has dampening corporate event driven opportunities in Europe year-to-date. Additionally, as industry participants look to manage their binding constraints, the emphasis on regulatory capital friendly structures or more diverse collateral types is a continued theme that presents potentially positive opportunities.
What investments and adaptations to working practices have you made to sustain and grow your European securities lending activity in this environment?
Jones: We continue to invest heavily in our technology, our products and our people. We have invested to ensure our trading teams and our clients have access to comprehensive real time data and analysis which is critical to navigating in periods of volatility or uncertainty. As well as enabling us to manage the risk such an environment presents, it also allows rapid assessment of opportunities and provides our clients with comfort that they have full transparency into their programme and can use our data to contribute to the optimisation of their activity. It has become increasingly important to our clients to view lending as one part of a total portfolio approach, and by providing them with access to data and an integrated set of securities finance products, they have the tools they need to manage risk, fulfil their collateral obligations and generate meaningful returns.
Schuetze: As one of the largest agent lenders in the world, we constantly work on our setup to meet the needs of our customers.
A major step for us is the expansion of our continental European footprint. In addition to the Eurex Repo Clearing membership, we also have a strong local financing team and have extended our research footprint in the region. One of our core business objectives is to further strengthen the global State Street Financing Solutions business in continental Europe. In our opinion, the rather volatile current environment is supportive because it forces all of us to rethink our setups.
Chamberlain: With the continued focus on a streamlined end-to-end workflow, automated trading has been key in supporting increasing volumes, and we have adapted our operational processes to incorporate vendor solutions to enhance the efficiency of our trading workflow and proactively manage the number of breaks and fails. We have also been looking to grow our business through alternative trading platforms which have facilitated both price discovery and best execution.
The recent volatility has increased our focus on risk and control oversight, which has become crucial for sustaining a well-functioning lending business in this environment. We have configured key indicators to help us identify and track the risk associated with particular assets, and investment in this methodology has allowed us to differentiate our lending business through effective book management and risk-adjusted pricing.
What impact has monetary tightening had over the past 6-12 months on lending opportunities and collateralisation strategy in Europe?
Jones: Aggressive interest rate increases have been prevalent across many financial markets, but the ECB’s monetary policy has perhaps had the greatest impact on sovereign debt repo and securities finance activity. We have witnessed a number of core European bonds trading with a specials premium while, more recently, liquidity conditions have become somewhat stressed as the ECB lowers its presence. The central bank has sought to reduce accommodative monetary policy and unwind their significant bond holdings bought as part of quantitative easing programmes. Moreover, increasing sovereign yields have resulted in lower prices and collateralisation challenges. To mitigate the risk, Northern Trust has sought to expand our collateral eligibility, looking at new asset types and trade structures; including the expansion of our pledge offering.
Schuetze: The tense financing market in the first three quarters of 2022 led to an imbalance between liquidity and scarce collateral. This became particularly clear when the ECB started raising interest rates. Money market rates have been slow to follow suit because demand for HQLA has been so high. This also underscores the importance of alternative sources of collateral such as peer-to-peer models.
The current inflation situation in the EU is unlikely to change in the near future, so the use of cash collateral is currently more interesting than in recent years and will remain so.
The expectation of rising interest rates increases short-term interest in EU bonds and offers lenders the opportunity to generate higher excess returns for their portfolios, while agent lenders are facing higher opportunity costs when using risk-weighted assets (RWA) through indemnification.
What expectations do your clients have from you as a service provider in supporting their commitment to sustainable lending and borrowing? Have recent market conditions and geopolitical stresses had an impact on demand for ESG-compliant lending solutions?
Mansfield: To meet our clients' expectations, BNY Mellon’s securities lending programme is designed to be inherently flexible, so clients can align their lending programme parameters with their ESG strategies. Supporting our clients who have developed ESG and sustainability policies, BNY Mellon clients have transparency on ESG data points across their agency securities lending programme. Our programme capabilities provide visibility into securities lending, enabling clients to apply ESG scores to their lendable portfolio, their collateral and their cash investments. The functionality draws on MSCI ESG Ratings delivered through BNY Mellon's Data Analytics platform, allowing clients to validate daily that the collateral they receive and the investments they make are within the tolerance levels of their own ESG investment policies. At an industry level, BNY Mellon is actively working with trade associations, ESG labelling bodies, policymakers and regulators to evolve best practices for the consideration of ESG factors in securities lending.
Recent market events and the geopolitical landscape have further highlighted that ESG policies will inevitably vary between clients as they assess financial risks and materiality in the context of ESG factors. As we have seen, there is no single approach to ESG and this has only been further underscored by the current economic and geopolitical landscape.
Schuetze: ESG has been an important topic in the securities lending industry for a while, particularly in Europe. The last few months may have accelerated this trend somewhat, but the requirements are clear: transparency, compliance and integrity.
Socially responsible investment and ESG are important parts of our loan programme that support our clients’ needs. The main issues that we discuss with clients regularly are around collateral schedules, voting and proxy voting, but also the effect of short selling on markets and portfolio performance.
Jones: Being able to support our clients’ ESG approach is absolutely critical. If we go back a decade, ESG was a topic that came up in perhaps one in 10 onboarding conversations. Now it is every single one. The approaches remain varied from client to client, so we have focused on implementing a wide range of solutions that allow our clients to feel comfortable they can operate a sustainable programme with our support. The ability to exercise good corporate governance through voting at AGM or EGMs remains the most common requirement and we have a number of options that help clients to achieve that.
How do you assess the outlook for European securities lending markets for the remainder of 2022 and into 2023?
Schuetze: We expect an ongoing borrowing demand throughout all asset classes. The elevated volatility is an important factor for the derivatives markets which needs to be hedged. Clearing obligations increase stability and at the same time increase the demand for collateral optimisation. We see an ongoing trend to outsource non-core asset management functions.
Securities lending is one of these functions, and our clients and prospect clients are showing stronger interests in securities lending, given the alpha it can help portfolio managers to generate while these firms focus on maintaining a cost-effective operation that is laser-focused on what they do best — managing assets.
Dinh: Looking into the remainder of this year and into 2024, we expect the lack of conviction to continue, with the exception of a few key names that stand out. With many firms long cash, the need for rights issues and corporate actions may be limited to certain pockets driven by distressed names, the need for reorganisation and to repair balance sheet, along with reductions in scrip activity — with firms opting for cash-only payments. With the heightened focus on capital and RWA, new methods of mobilising assets with vendor partners, increased financing solutions opportunities, and emerging technologies such as digitisation and tokenisation impacting both ASF and collateral, market participants’ ability to adapt their trading models will be key to whether they can capitalise on prospects within the next 18 months.
Mansfield: Regulatory capital and indemnification cost for securities lending and SCCL limits continue to remain challenging. Cleared repo volumes are continuing to trend higher and there remains an opportunity from both an increased collateral supply and regulatory perspective to become active across regions in the cleared repo space. The growing need for European lending CCPs has become increasingly important to help the market navigate these challenges.
