Just 6.8% of the available global securities are on loan, fairly evenly spread across lendable securities around Asia, America and Europe, according to Markit Securities Finance calculations.
But Canada is a particularly interesting market, with utilisation high at around 10%, because many of its companies are resource and big oil companies that pay scrip dividends.
“Scrip trading is quite a profitable trade in securities lending, because it lets you play the optionality of the dividend payment and is a good source of market neutral revenue for beneficial owners such as pension funds,” says Markit Securities Finance analyst Simon Colvin.
“In Canada, balances are all over the place as these companies pay their dividends. The larger the dividend, the more optionality there is.”
Several Canadian firms are looking to expand their presence in North America. For example, BMO Capital Markets has leveraged the securities lending team and assets of Paloma Securities, which it acquired in 2009 to build up its equity finance capabilities.
Tony Venditti, managing director and global head of BMO Capital Markets’ Global Prime Finance Group, based in New York, says: “We have been focusing on IT and infrastructure in order to strengthen and grow our global platform.”
BMO has offices in the UK, Ireland, Australia, Canada and the US, and he says BMO is “integrating and aligning systems to realise even greater efficiencies”.
Securities lending is mature in the US, so it has been easier for BMO to connect to multiple counterparties and pockets of supply and demand.
“As European markets and banks come out of a very challenging credit environment, I believe there will be many opportunities that could drive growth. This seems to have started especially after the past 18 months of positive returns in most core European markets. I personally think that Europe will be more of a growth opportunity in the next few years, as Asia has become over time.”
BMO currently has a more established presence in capital markets and more distribution points, so “there is a clear opportunity to win more North American business from European clients and it is also easier to expand closer to our North American time zone”.
One driver to expansion is that clients are more demanding and expect global reach. “There is a lot more transparency in the securities lending business with much more activity around the renegotiating of daily rates on multiple securities,” Venditti says.
“The underlying clients seem to have a better idea of the risks they are taking and how much they are getting paid for those risks. Additionally, the increased regulatory scrutiny ensures everyone is paying attention to how their portfolios are being lent, as well as to the spreads that are earned.”
Large lenders typically set a high profit split in favour of their clients in order to encourage lending activities, but now the underlying client demands more, especially around what happens to either the reinvested cash or the collateral and the spread earned on both. In the past, lenders would concentrate more on lending as many assets as possible.
“Today some clients do not want to lend many easy-to-borrow stocks because it is not worth the risk of the counterparty or collateral versus the small amount of spread they would earn, and so they tend to focus on specials and hard-to-borrow stocks that generate a more attractive fee for lenders and their clients. This is a hard juggling act, to keep both the borrowers and the lenders of securities happy.”
A drive for efficiency, global reach and a more customised client service is also the story at BNY Mellon and CIBC Mellon, its long-established Canadian joint venture with Canadian Imperial Bank of Commerce, which merged securities lending desks last October to create a lending giant, enhancing service for BNY Mellon’s global client base in the Canadian lending market, as well as working with Canadian players as they expand their reach through BNY Mellon’s global network.
James Slater, global head of securities finance at BNY Mellon, says BNY Mellon’s global expertise has been made available to CIBC Mellon clients to provide them with new opportunities for incremental revenue in markets around the world, while CIBC Mellon’s expertise in the Canadian market has enabled BNY Mellon clients to improve their returns on Canadian securities.
Slater believes emerging markets – particularly Taiwan, Thailand, Malaysia, Korea and Brazil – offer attractive opportunities because this is partly a flow business and there is much less supply of stock available in these countries.
BNY Mellon has five securities lending trading desks globally, with its offices in Hong Kong facilitating distribution in the region. Maple Bank, a privately-held Canadian financial organisation, also restructured its securities finance team in November 2012, and promoted Walter Kraushaar to oversee its expansion into the US.
It is trading with more than 150 securities finance participants internationally, with a perceived competitive advantage, according to the bank, in the close collaboration between the treasury and securities finance departments that produces more customised solutions.
Maple Bank is one of the second-rung players to sign up to Eurex Clearing’s central counterparty (CCP), along with DekaBank, ING Bank, Natixis, Nomura International, Societe Generale and Santander Global Banking & Markets. CCPs, run by firms such as OCC, LCH.
Clearnet and Six X-clear, will offer much improved capital efficiency under Basel III. Under existing Basel II regulations, there is a 0% risk weighting for transactions cleared via a CCP, and when Basel III regulations take effect, existing OTC transactions will face higher capital charges than the 2% charge that will apply for exposures to a CCP. Borrowers using centrally-cleared transactions can therefore free up capital earmarked for securities lending transactions and use it across their other business lines.
On the whole, other Canadian banks, such as Royal Bank of Canada and Scotiabank, are also well capitalised and able to cope with Basel III, and are better placed to move into the US than they are for Asia, where they typically lack scale.
Maura Drew-Lytle, spokesman for the Canadian Bankers Association, says: “For the most part, Canadian banks have enviably solid balance sheets and diversified activities that combine retail, commercial and investment banks in one financial group.
“Their investment arms are anchored by solid, deposit-taking retail banking operations. For six consecutive years the World Economic Forum has ranked Canada’s banking system as the world’s soundest.”
Europe is another attractive market, owing to its high-yield stocks. Around 7% of the region’s available stock is on loan, compared with 5.5% in Asia and America, and it is set to improve further as the economy recovers.
Gareth Mitchell, Emea head of securities lending at Citi, says: “A lot of securities are in demand, primarily around corporate actions and events and record dates, such as some southern European banks.
“This could reflect greater concentration on securities with reasonable value in their own right with no need for capital or collateral upgrade to create a return on that equity.”
Eurex recently extended the scope of its CCP solution for securities lending, including the acceptance of equities from Belgium, France and the Netherlands, and the capability to deal with the full range of voluntary corporate actions.
One opportunity in securities lending created by the new regulations is term funding, as Basel III forces banks to step away from overnight funding. Another is its ability to provide a conduit for collateral regulation as the 40% shortage in collateral widely predicted by the industry has proved not too wide of the mark.
Richard Glen, head of global securities financing, sales and relationship management at Clearstream, highlighted the rerating of Italian and Spanish government bonds.
“The immediate flight to quality after Lehman Brothers’ collapse into high-quality assets such as US treasuries, German bunds and other high-grade government bonds has stayed with us, and together with sovereign debt downgrades in Europe a number of financial institutions are looking for broader collateral and so are looking at Canada, Switzerland and Australia for new sources of high-grade liquidity that they can use for the liquidity required.
“One thing we do is to factor in the movement of assets, and one of the issues about high-quality collateral is its scarcity. But when push comes to shove, counterparties need to access high-quality assets at speed.
“The banking community needs a means of streamlining the collateral and improving visibility, with wider diversity.”
Consequently, more participants are looking at securities lending as a means of sourcing high-quality assets.
“The regulations will impact people in different ways, but will also create opportunities,” says Slater. “There is much greater complexity for moving collateral around and collateral management is one of the big businesses we are in. We are leveraging that with our securities lending capabilities, using our core systems to provide a better service to clients.”
For the beneficial owner, securities lending can deliver 5bps to 10bps of pure alpha with relatively little risk or effort.
“We are seeing more dialogue around how the regulations will impact pricing for beneficial owners, bankers and dealers as the cost of capital that needs to be set aside has gone up quite a bit,” adds Slater.
“The discussion centres on whether beneficial owners should bear the additional costs, as, for example, the costs of indemnification have gone up for the lending agent. Splits are not static and are largely reflective of the underlying asset demand.
“In spite of these changes, it is a good time for beneficial owners to consider lending programmes as there have never been more options available to customise programmes to suit their risk appetite.”
A recalibration of the securities lending market has been anticipated for some time as a battalion of regulatory initiatives line up against it.
However, in the past few months the economic backdrop has been improving and corporate activity has been reignited, generating strong demand in the borrowing of hot stocks to be sold ahead of mergers, and selling opportunities in new issues that need to be covered with borrowed stock.
Hedge fund allocations to long-short strategies have also returned to their highest levels in four years, spurring a cyclical recovery in the stock lending market.
So far, only Q4 2013 figures are available, but despite widespread forecasts that margins on securities lending business will flatten, a look at the largest investment banks’ results reveals they have been able to spread their costs over a larger lending universe, improve their efficiency and expand their definitions of acceptable collateral.
State Street, for example, reported securities finance revenue of $76m in Q4 2013, an increase of 2.7% on both Q3 2013 and Q4 2012, while Northern Trust’s securities lending figures for the same period were up by 7%.
According to Markit Securities Finance, inventories have reached an all-time high at $15.1trn across all asset classes globally, compared with $13.3trn a year ago, but utilisation rates have fallen, from 12%-13% in 2011, to 10% in January, though they have now recovered to 10.5%. This compares with twice the utilisation, at levels of around 21%, in 2007.
“There are record high inventories in lending programmes, but utilisation rates, profitability and fees are all sliding downwards,” says Markit’s Colvin.
This reflects the reality that some 80% of revenues now stem from a small number of specials, such as Blackberry and Vesta Wind Systems, while only 20% of revenues are derived from the general lending programmes.
This phenomenon favours financial firms with a diverse lending base and exposure to these popular assets, and leaves the marketplace somewhat disparate.
Certainly, there is not much movement in firms entering or exiting securities lending. Instead, lending agents have been focusing on building their presence in particular geographical territories in a hunt for scale and improved margins.
In recent years, most firms have viewed Asia as offering the best markets for potential growth, but with so many providers chasing the same territories, margins are becoming thinner in many of these markets as they approach saturation, with the possible exception of Korea.
Citi’s Mitchell says: “In our global book, Asia has been the star for the past couple of years, but recently many markets in the Asia Pacific region have begun to look oversupplied.
“For example, average spreads in Taiwan have halved in the past two years. Spreads that were previously attractive have been eroded as new supply came in, but still compare favourably to most other markets.
“Lenders have seen revenues drop in Europe and the US and have been looking to see where they can pick up yield.”
Some of the smaller lenders may withdraw as they will lack the scale required to run a securities lending programme once the many regulations take effect.
“There are too many issues to contend with for the revenue they would get back,” he says.
Citi recently bolstered its securities lending operations in Russia.
“The rationale is to go into markets where our investor base is holding securities,” says Mitchell. “There was demand from Russian companies, and more beneficial owners have been buying Russian securities.”