Which side of the business are regulations affecting the most at the moment?
While there is still some significant regulatory uncertainty with respect to single counterparty credit limits, the net stable funding ratio, and financial transaction taxes, we do have clarity around capital, leverage and the liquidity coverage ratio and those items are beginning to influence behaviour in the securities lending market.
Currently, it appears that the demand side, specifically the borrowers, is the most affected by these changes. The leverage ratio, originally designed to be a back-stop to the capital requirements, has now become the constraining measure for most of the large dealers. As a result, many of these firms are reducing their overall balance sheet, looking to structure transactions that are balance sheet friendly, and reviewing clients and business lines to make sure they provide sufficient return on leverage capital.
This is also driving an increase in lending transactions collateralised by securities. This puts increased emphasis on collateral flexibility for agent lenders and beneficial owners as greater collateral flexibility will drive increased utilisation.
Capital requirements and the leverage ratio are also causing an increase in interest around the utilisation of central counterparties (CCPs). This has always been a topic of conversation in the securities finance space, but now it is getting more serious attention from market participants. It seems almost every CCP has a committee or group working on potential solutions for the securities finance market.
The liquidity coverage ratio is the other requirement that is changing behavior of the dealers. This ratio requires large dealers to maintain a sufficient supply of high quality liquid assets to meet potential net outflows of liquidity over a 30-day stress scenario. This is driving an increased demand for term financing structures on the cash collateral reinvestment side of our business. It is also creating demand for borrowing high-quality liquid assets such as treasuries for term against other types of security collateral. We expect to see this continue, which may contribute to wider spreads and increased lending and reinvestment opportunities for our clients that can engage in these transactions.
What about agent lenders and the buy side?
The calculation methodologies for securities finance transactions under the single counterparty credit limits of Dodd-Frank Section 165(e) are not yet finalised. As currently proposed, the regulation creates a calculation of credit exposure that far exceeds the actual economic risk inherent to these types of transactions.
Also, the calculations do not recognise the benefits of correlation between the loan and the collateral portfolios. If adopted as proposed, this would have a significant impact on the buy side as it could limit the ability of agent lenders to provide the traditional counterparty default indemnification that many clients require to participate in the lending market.
We are working with regulators and other market participants to recommend alternative calculation methodologies that achieve the regulators’ goals and preserve the ability to continue to provide counterparty default indemnification. In addition, we are also expanding our approved counterparties to create more diversification and developing new methods and structures to distribute our clients’ assets.
The proposed financial transaction tax in Europe could also affect beneficial owners and agent lenders. The tax as initially proposed includes securities lending and repo transactions. Also, the extra-territorial nature of the tax could impact many transactions outside of the specific European jurisdictions.
How has 2014 shaped up for securities finance business?
We are already half way through the year and it’s been good so far. BNY Mellon’s investment service fees totalled $1.7 billion in Q2 2014, a 1 percent increase over the previous quarter, partly thanks to higher securities lending revenue. State Street and Northern Trust did similarly well. No one region stands out as the main contributor to that success, although from an asset class perspective, US equities have been particularly strong this year, which partly also benefited from our continued investment in new trading tools or enhancements to existing technology to capitalise on that trend. We expect heightened mergers and acquisitions activity to contribute to a solid end to 2014.
Also positive to note is beneficial owners that suspended their securities lending programmes around the financial crisis continue to return to securities finance. BNY Mellon welcomed back a decent sized plan in June 2014, and we are seeing between 10 and 15 return every year. We have also seen many beneficial owners that reined in risk post the financial crisis adjust their programme or collateral guidelines to increase opportunity.
How are beneficial owners treating securities finance and collateral management in light of a collateral squeeze through regulation?
Beneficial owners continue to be interested in the intrinsic value of the business and understand both how essential the liquidity it provides is and also the other benefits to the financial markets. Changing regulation is not a concern but more a curiosity on how it will affect future revenue streams and opportunity. I believe this is in part because they see the regulators efforts to reduce systemic risk and make financial markets safer as being in line with their interests.
Many beneficial owners have or are re-visiting their programme guidelines, expanding their programmes and/or expanding collateral guidelines. Europe has always been more open to non-cash collateral in general, but now US beneficial owners are more open to accepting a wider variety of non-cash, including equities. They see how the new regulations are changing the markets and where they are creating new opportunities.
Many beneficial owners are also becoming much more focused on their own liquidity and collateral needs as the new rules for central clearing of derivatives are creating the need to post initial and variable margin to support this activity. Securities lending can play an important role in helping beneficial owners manage their collateral and liquidity needs.
What can we expect from 2015?
I am optimistic that 2015 will be a good year for securities lending. It’s important not to measure today against 2007 and 2008, as those were anomalous record highs right before the crisis. It’s more appropriate to compare against 2006 and earlier, which were much closer to where we are now. Two thousand and thirteen was very much about getting back on track, and 2014 has been solid, so I expect 2015 will see us continue to get stronger.
In 2015, the borrower side will continue to see change. The providers or banks that can optimise from a capital and balance sheet perspective and also accommodate borrower demand for collateral will do the best in this new environment.
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