2014 was a very active year for securities lending. A dizzying array of new regulations were proposed, discussed and evaluated; counterparty indemnification and margin rules dominated the debate. CCPs began to expand, with at least one CCP now able to accept buy-side market participants directly. Overall securities lending volumes declined while Asian volumes rose. This article takes a look at some of the main takeaways from the securities lending industry in 2014, and then a look at what’s ahead in the coming year.
Data Show Increased Non-Cash Use, Overall Declining Volume
According to SunGard’s Astec Analytics 2014 market data, global securities lending positions rose through dividend arbitrage season then fell steadily, ending 2014 at under US$1.5 trillion, which is net down 10% over the year (Exhibit 1). This is the result of multiple market and balance sheet factors depressing borrowing demand and despite rising equity markets. Equities, US Treasuries, and Corporate Bond asset types continued to dominate the market with a 56%, 16% and 12% market share make up, respectively, at year end. (Exhibit 2). The year saw the use of non-cash collateral grow steadily from 44% to 52%. In Equities, non-cash use increased from 42% to 45% over the course of the year. It is no surprise that non-cash collateral will be a much more important part of the securities lending landscape than ever. The data show this already occurring.
On a geographic basis, slight increases in Asian and North American lending reduced some of the impact of declines in European lending. On a percentage basis, Asian loan volumes rose by 8%, North American volume was up 5% and European volumes declined 14% (Exhibit 3). The reality is however that Asian markets, while carrying high securities lending fees, are in limited supply. A potential opening up of Chinese markets in 2016 or 2017 could change this equation dramatically.
Many hard-to-borrow stocks rose up and fell throughout the year with notable securities spanning across several industries. Throughout the spring, retail industry giants such as Sears Holding Group (SHLD) and J.C. Penney Company (JCP) dominated the markets with their struggling balance sheets and flailing consumer appetite for their products. In the latter parts of the summer, tech companies such as Alibaba Group Holding Ltd (BABA) and GoPro Inc. (GPRO) both came out with Initial Public Offerings, and supply dried up in anticipation. Spain’s Gowex and the UK’s Quindell were both shown to be engaging in questionable or fraudulent business practices, leading to dramatic share price declines and in Gowex’s case, bankruptcy and an admission of guilt from the CEO. Closing out the fall and into the winter months, we saw oil stocks like Goodrich Petroleum (GDP), Sandridge Energy (SD), and Transocean feeling the heat from short sellers’ pessimistic outlook due to the crisis in Ukraine, economic sanctions against Russia, and the glut in supply from OPEC member inventories and new supply coming online that pushed the price of crude down 50%.
Regulators worldwide have continued to keep the industry hum on rule making. At the start of last year, the European Commission released a proposal for the establishment of a central database for Secured Financing Transactions (SFTs), suggesting that all securities financing transactions be reported to a central repository much like that of exchange based or OTC markets. In May, the US Financial Stability Oversight Council echoed the call for securities lending data transparency and questioned whether some securities lending programs could support their indemnification offerings. In October, the Financial Stability Board revised and updated their opinion on “Strengthening Oversight and Regulation of Shadow Banking Regulatory Framework for Haircuts on Non-Centrally Cleared Securities Financing Transactions.” Included in the report, the FSB expanded regulatory coverage to that of non-bank entities, as well as increasing the minimum haircut floor for securities-against-cash transactions.
And who can talk about securities lending without the mention of central counterparties (CCPs)? With growing regulatory concerns between liquidity, risk, and leverage – it’s easy to see why CCPs are paving the way in the evolution of securities lending. While the dealer community sees CCPs as a capital utilization opportunity, beneficial owners are only slowly adapting; this is an important topic for the coming year.
The debate about indemnification will continue. We suspect the argument made by the dealers will be that CCPs remove the need for indemnification, but there will be plenty of pushback from beneficial owners who are used to the security blanket of indemnification and are reluctant to give it up. Agent lenders will be reluctant to give up indemnification as a major differentiator for their programs. But first the market needs to resolve the central issue for beneficial owners on CCPs: how do I know if the credit quality of the CCP is as good as my approved counterparties? This will require due diligence and a better understanding of the risk waterfall and default recovery mechanisms of the CCP itself. The debate on the “best” CCP products is currently very active on this topic.
Regulatory matters should be taken very seriously by market participants. In fact, they impact the very foundations of not just securities lending but also financial markets. Prior to 2015 we have seen substantial conversation but not much concrete action. We expect 2015 to mark an important change in this regard.
Projections for 2015
Let’s polish off our dusty crystal ball and make a few projections on what’s to come in 2015.
- We expect 2015 lending volumes to remain on par with 2014 performance, including volumes associated with its respective asset types and geographic regions. While we expect general collateral volumes to fall due to regulatory cost pressures, 2015 may be too early to see this impact in full.
- Although we hope to see the landscape in Chinese Securities Finance continuing to open up, odds are it will be a few more years until anyone feels any real impact, especially on the securities lending front. Meanwhile, Chinese regulators are working to find a balance between regulation of Shadow Banking and encouraging market development.
- 2014 got off to a slow start, but 2015 will be the year CCPs are actually utilized. With Basel III regulation introducing the Liquidity Coverage Ratio (LCR) and the Net Stable Fund Ratio (NSFR) we’ve already felt a dynamic shift between lenders and borrowers within securities lending, further strengthening the rationale behind CCPs. At IMN’s Beneficial Owner’s Conference in London, the audience was asked what percent of the market would migrate to CCPs: 75% of respondents said that CCPs would capture under 40% of the market, with only 12% suggesting CCPs would capture over 70%. Although we might be a bit hesitant on the latter suggestion that CCPs will dominate the market, we do largely expect to see participants starting to make the move. US markets are behind European on CCP acceptance but that will change in time.
- Conversation on regulatory evolution will continue, including back and forth adjustments on capital costs for securities lending transactions and risk management at CCPs. The most pressing issue may be the Financial Stability Board’s “Regulatory Framework for Haircuts on Non-Centrally Cleared Securities Financing Transactions” and how it changes what is required from end-clients. Some bilateral participants may find it more advantageous to transact with bank or CCP counterparties in order to avoid mandated haircuts. Other contenders for critical regulatory contributions are Trade Repositories, which are gathering steam in securities finance, and whether CCPs could become mandated for securities loans.
Overall, we believe securities lending will follow a similar path to its former-year-self. Continued discussions on the regulatory front, the acceptance and implementation of CCPs, and the potential for many headaches along the way. We see securities lending in 2015 as paving the way for not only greater transparency, but also a greater push towards internal efficiencies in liquidity and collateral at market participants.
We look forward to continuing the conversation in the coming year.
David Lewis is Senior Vice President, Astec Analytics