NN Investment Partners
Xavier Bouthors, senior portfolio manager, investment solutions, NN Investment Partners, talks to Bob Currie about responsible investment, sustainable lending and the direction of NN IP’s securities finance strategy
In its mission statement, NN Investment Partners (NN IP), the Netherlands-based fund manager, highlights the importance of managing assets responsibly — “because it is important and it works”. As a responsible investor, NN IP aims to improve client returns and the world we live in. “We do this by looking beyond finance performance, because the people we work for, and with, represent more than the investments we manage,” it says.
In line with this objective, Xavier Bouthors notes that a commitment to sustainable development has been central to the evolution of NN IP’s securities lending strategy. In recent years, the asset manager has been working closely with stakeholders across the loan transaction value chain, alongside industry associations and responsible investment groups, to promote sustainability parameters in lending activities.
This involves considerations ranging from voting strategies and procedures for stock recall, to collateral screening and exclusion, alongside steps to monitor the responsible investment standards of its lending counterparties, for example alignment of codes of conduct and tax principles.
NN IP has developed its securities lending programme to comply with the Dutch Stewardship Code, along with the second EU Shareholder Rights Directive (SRDII) and the Principles for Responsible Investment. Its day-to-day practice is also influenced by the Bank of England’s UK Money Markets Code of Conduct which guides best practice in unsecured, repo and securities lending markets.
The investment group is an active participant in the International Securities Lending Association (ISLA) ESG working group. It was also one of 17 opening signatories to the Global Principles for Sustainable Securities Lending, a community of organisations working to develop a global market standard for sustainable lending according to a principles-based approach.
NN IP currently has close to €300 billion in assets under management, of which 74 per cent are ESG integrated, according to the firm.
On 19 August, NN Group issued a joint statement with Goldman Sachs indicating that the Hague-based investment manager will be acquired by New York-based Goldman Sachs group for close to €1.6 billion. The deal is expected to close by the end of Q1 2022. It was too early at the time of interview to reflect on how this acquisition will affect the firm’s approach to securities lending.
How do you assess the performance of NN IP’s securities lending programme over the past 12 months?
For the year-to-date, we have experienced year-on-year growth in securities lending revenues, accompanied by new trading opportunities and greater openings for collateral upgrade transactions. Banks are looking to access high-quality government securities on an evergreen basis, delivering lower quality assets as collateral. We are constantly assessing with our clients the trade-off between risk and reward, for example accepting a wider range of collateral or applying different haircuts in return for better returns.
At NN IP, we support a number of different types of client. This includes multiple UCITS portfolios, but also pension and insurance portfolios within the group. We have also had new third-party clients joining our securities lending programme. There have been attractive opportunities to generate value for institutional investors from term trades as they align well with the relatively stable buy-to-maintain liability-driven investment (LDI) portfolios. These are a valuable, stable source of high-quality liquid assets (HQLA) for collateral transformation term trades.
Fee rates have varied substantially depending on the asset class and the borrower. But, in broad terms, we have seen revenue growth across a broad range of equities, as well as high-yield debt and emerging market government debt.
This said, we do not endorse headlines in some parts of the news media that 2021 has been a bonanza year for securities lending. We do not see the market in those terms currently, particularly because some of the highest revenue earners have been concentrated in specific equity and corporate bonds specials that we do not always hold.
So what has been driving growth through your lending programme?
Particularly through deepening our lending activities with counterparties where NN IP has wider trading relationships. We have been able to leverage these trading links to extend loan volumes and ensure attractive returns and utilisation. Some counterparties choose to interact directly with NN IP on more structured trades — perhaps not wanting to reveal insights to an agent lender about their trading strategy or how they position themselves from a pricing standpoint — and are attracted by opportunities to access loan supply through NN IP’s lending programme building on existing links between the two organisations. The collaboration with our agent lender, Goldman Sachs Agency Lending, was key to support this.
At the same time, NN IP has applied tight scrutiny to our list of eligible counterparties, evaluating these firms not just for credit risk, but also to ensure they comply with the sustainable investing criteria that we apply across our investment and lending programmes.
For UCITS portfolios, there are restrictions on how we lend and what we can accept as collateral. UCITs are tightly regulated in terms of the risk they can take on through lending activities. ESMA rules dictate that assets held in UCITS fund portfolios cannot be used in term trades (ie loan transactions should be for no more than 7 days) and collateral accepted in lending transactions must meet specific credit-quality requirements and concentration limits.
From a geographical perspective, we have made incremental rather than far-reaching changes to our lending coverage. NN IP has been active in equities lending in most developed and emerging markets where we have securities in inventory and where lending is permitted.
This is also the case for emerging markets debt (EMD), particularly for foreign-currency government bonds. We identify selective opportunities to expand our lending for local-currency government bonds in some emerging markets. However, this will be the result of detailed due diligence and evaluation of local regulation and market practice, which can be complex for local currency EMD lending in some jurisdictions.
In recent market conditions, we have noted some lenders have been willing to look further down the credit-quality spectrum in terms of collateral they will accept in repo or securities lending transactions. Given the near-zero (or sub-zero) interest rate environment and the abundant liquidity that has been available since the start of the year — the product of massive central bank liquidity interventions since the onset of the Covid-19 crisis — it remains problematic for firms that are long cash to generate an attractive yield on their cash holdings. Some firms have been willing to widen their collateral tolerance in search of additional yield.
At NN IP, we have taken a cautious approach to widening our collateral eligibility, recognising that in the event of counterparty default we must be able to liquidate collateral within our required timeframe — and that this may be difficult for illiquid or lower credit-quality assets in conditions of market stress.
What are the key lessons learnt over the past 18 months?
The first lesson is that liquidity can dry up very quickly. All firms that rely on secured financing transactions to meet their funding requirements must have a strategy in place to protect their access to liquidity as conditions tighten. The repo market spike in the US triggered significant liquidity tightening during Q4 19 – and then the Covid-19 pandemic sparked severe tightening in the EU commercial paper market, creating pressures on short-term funding, from March 2020.
This experience has reinforced how important strong trading and funding relationships have been in helping us to negotiate these challenges. Internally, this also reinforces the importance of the rigorous scenario analysis and stress testing that we conduct to model our resilience under different types of market distress.
We have read a lot about potential collateral scarcity, but we see little evidence of this developing in current market conditions. Central bank asset purchasing programmes have sucked in large volumes of high-quality assets, causing central bank balance sheets to expand to unprecedented levels. However, high levels of government debt issuance, used to finance government interventions during the Covid-19 crisis, have largely offset any potential shortage of high-quality liquid collateral.
There were advanced warnings of liquidity tightening as we moved towards the 2020 year-end — triggered by banks looking to reduce their balance sheets in preparation for their year-end reporting — but in practice the year-end was negotiated with little disruption to the market.
As we moved into 2021, the Archegos insolvency has reminded us that defaults do still happen and these can result in large losses for investors and banking counterparties. This point was made forcefully 13 years ago with the collapse of Lehman Brothers, but the passing of time should not lead us to underestimate current risks or to relax our threat detection framework. Several banks suffered major losses as a result of Archegos, but they are still in business. Had one of these defaulted, we need to be clear how this would have affected our business and be sure these risks were properly mitigated.
In light of G20 reforms, and internal lessons learnt from the financial crisis, do you feel safer than you did in 2008?
Only in certain respects. Archegos exposed some of the dangers embedded in bilateral relationships between a hedge fund and its bank counterparties. Reforms introduced after the 2008 financial crisis — for example, to encourage central counterparty clearing of securities and derivatives transactions, to require reporting of OTC derivatives transactions to a registered trade repository — did not prevent the Archegos default or provide significant early warning to financial regulators. Archegos’ swap positions, for the most part, were not centrally cleared and margin requirements were managed bilaterally between the fund manager and the bank’s prime services division.
What role do agent lenders, tri-party collateral managers and other external specialists play in supporting your programme? And how is this changing?
This is a highly competitive market, with agents knocking on the door to win new business from buy-side lenders. However, we have used the same agent lender since 2008, when NN IP first entered the securities lending market, and we have had strong continuity with this service provider.
In fulfilling our stewardship responsibilities, it is imperative that we have strong oversight of outsourced service relationships and provisions in place for benchmarking service quality. Our agent lender has met our service requirements consistently during recent periods of market uncertainty and this has been borne out by strong service performance benchmark scores. With implementation of the Securities Financing Transactions Regulation (SFTR) in 2020, our service provider also played a key role in delivering an outsourced reporting service that ensures our compliance with this regulation.
We have taken the decision to extend our tri-party collateral management options over the past two years and now employ two tri-party collateral specialists rather than one. Typically, the choice is driven by the needs of our counterparties. When trading with a counterparty’s fixed income desk, typically this will dictate that we use Euroclear as tri-party; when dealing with a firm’s equity desk, this will direct activity towards BNY Mellon as tri-party agent.
As a collateral receiver, we are well equipped to support efficient collateral movement through these third-party relationships. The challenge is to put our collateral inventory to optimal use, identifying whether we can be most efficient through posting a piece of collateral as initial margin, in meeting requests for variation margin, deploying this in securities lending or repo transactions, or through other uses.
Looking ahead, what are the immediate priorities for your securities lending and financing strategy?
Regulatory changes will be a primary driver. We continue to review our responsibilities as a sustainable investor, including how our obligations under the Sustainable Finance Disclosures Regulation (SFDR) will impact our approach to securities lending. We have drawn on internal opinion from NN IP’s in-house regulatory experts, as well as key information sharing via the International Securities Lending Association’s (ISLA’s) ESG working group and Beneficial Owner group.
NN IP’s approach as a buy-side lender is that under SFDR Article 6 and Article 8 (‘light green funds’) fund assets may be used for lending, providing that we have approval from the relevant portfolio management teams.
In addition, we are currently preparing for implementation of the settlement discipline regime component of the Central Securities Depository Regulation (CSDR), which is scheduled to become active in February. We are monitoring the potential drag this imposes on our lending activity, when the potential costs of fulfilling reporting requirements are taken into account, alongside any potential costs of settlement fines and mandatory buy-ins. Although some markets have operated settlement fines and voluntary buy-in provisions for a number of years, this will take on a different weight when mandatory buy-ins are enforced through regulation.
Notwithstanding the volatile market conditions that we have encountered over the past 18 months, more institutional investors are now exploring the potential benefits that securities lending can deliver in this low-return environment. This has resulted in new potential beneficial owners entering the market and more lenders entering into dialogue around shareholder engagement and sustainable investment principles. This can only be healthy for the industry.
