In a wide-ranging conversation, Securities Finance Monitor speaks with BNY Mellon’s Bill Kelly, Global Head of Agency Securities Lending, and Mike McAuley, Head of Product Development and Strategy for Securities Finance, on client control of the lending process, CCPs, product convergence and more.
Securities Finance Monitor: Securities lending has been in the public eye lately with the GameStop hearings. What message would you like to deliver to clients, regulators and the public about the business?
Bill Kelly: It may sound like the usual story line, but securities lending and short selling contribute to efficient markets through price discovery, liquidity and rooting out poor corporate governance. Both practices have been challenged before and each time, regulators have come to their defense. The volatility we’ve seen around GameStop and the events surrounding it may be a new circumstance that requires a review, but nothing has changed the basic premise of the contribution that securities lending brings to efficient markets.
Mike McAuley: The events around GameStop and Reddit in January forced most short sellers out of the market. This was harmful to price discovery and may have resulted in some investors overpaying for the stock. These events could be viewed as highlighting the importance of short selling in maintaining price efficiency. The more views both positive and negative that can be expressed in the market, the more likely that investors will receive fair value.
BK: It’s important to note the consistent smooth functioning of securities lending and securities markets in general through periods of high volatility. We’ve seen up and down pricing through the Lehman default, the GameStop event and following fraud revelations like Wirecard, and securities lending and short selling have worked well to promote market efficiency during these episodes. Oftentimes, short sellers are out in front of the news and bring the biggest corporate frauds to light before anyone else.
Sometimes appreciating the value of securities lending requires a better understanding of the business. We find this is true for both clients and internal stakeholders at our own firm. If you start from a grounding in the principles of an efficient market, then the role of securities lending becomes clearer.
MM: When speaking about the role of securities lending, what sometimes get lost is that a large portion of the revenue benefits main street through public and private pension plans, 401(K) plans, and mutual fund investments. At a 2011 hearing before the US Senate’s Special Committee on Aging, Senator Corker stated that their calculations indicated that not allowing defined contribution plans the option of engaging in securities lending would have a detrimental impact, causing individuals to work longer to obtain their retirement goals. This additional income translates to money reinvested into the real economy and local communities. Yes, prime brokers make money too, but the impact on retirement savings always seems to be overshadowed.
SFM: We’ve seen a few attempts to launch a cleared securities lending product with limited success. What’s the future of cleared securities lending at this juncture?
MM: We support central clearing for securities lending and believe that it is necessary for the future of the industry and to support overall market capacity. The hard part is finding the right model. We have to work with industry participants to find a model that is acceptable to the beneficial owners and makes economic sense for all involved. Once we have the right model, we need to focus on improving the ease of adoption and participation.
We were disappointed when Eurex closed their Lending CCP. It was a very straightforward and simple model that we expected to grow more quickly. That said, the process of adoption and onboarding was challenging. Other models being developed are more complex and financially challenging, and that may slow adoption.
BK: Cleared securities finance transactions are a viable option. When you look at FICC’s Sponsored Repo program as an example, there are success stories out there with ample liquidity.
SFM: Do cost concerns about an equity lending CCP then become a case of equities volatility vs. fixed income volatility?
MM: The cost difference is linked to the volatility of equities and what that means for contributions to the default fund. The contribution might be 1% or 2% for Treasuries in FICC but that would be much higher for equities especially in times of high volatility. As the agent is only earning a small percentage of the revenue, supporting that level of default fund contribution becomes challenging.
Regardless, many in the industry are working on creative ways to support access, including asking clients to contribute to the default fund, leaving some of the cash collateral at NSCC, or having the borrower sponsor the client. We are looking into these and other options.
SFM: Beyond clearing, what other distribution channels are you focused on currently?
BK: We are looking at what different fintechs are offering as a means of accessing new liquidity pools. We’ve invested in HQLAx’s Distributed Ledger Technology (DLT) model. The opportunity there is that faster settlement, better exposure management and a lack of pre-posting of collateral could mean less friction and more efficiency for counterparties. A new level of interoperability between agents, borrowers and triparty could also be helpful.
MM: The instantaneous settlement and collateral inoperability across collateral agents provides benefits to the borrowers. Accordingly, we expect to see increased demand through this platform and we want to be ready to distribute our clients’ securities to meet this demand .
BK: We are excited about participating in a solution that potentially brings DLT to the fore. DLT has been talked about for years now and this is an opportunity to have a live experience.
SFM: It seems like there has been an important shift by agent lenders to be open to new technologies. Would you agree?
BK: Yes, there has been a sea change in agent willingness to engage. If there is liquidity and demand then it is important to have access.
MM: These platforms also provide new sources of data that help enrich our datasets and support our pricing strategies.
SFM: How are you seeing the evolution of clients looking to take more control over their lending activity? Are clients proceeding or is this on hold?
BK: Where firms have an internal competency with investments, there is an appetite to get involved with lending, but I don’t see a groundswell with firms that have interest. But both existing and prospective clients want to have a more engaged relationship with us as an agent. There are more data than ever suggesting this direction.
SFM: We’re hearing more clients talk about taking greater control of their lending programs. In your experience, what kind of control are we talking about? Is this more reporting, taking over the trading function, or something else?
BK: It starts with closer relationships between portfolio managers at the client and BNY Mellon’s trading team; this is really about better communication. We are also seeing some clients start to bring us transactions that they have agreed outside of BNYM with a counterparty, then we put those trades into our agency lending model and manage the full process. We refer to this as directed trades.
SFM: Custodial agents are talking a lot about product convergence. Is this really happening?
BK: We increasingly see buy-side clients wanting to optimize their financial resource management. We believe that UMR phase 6 will invite that even further with over 1,100 in-scope enterprises. Firms will have to organize their collateral around this regulation, including a need for good data across all their collateralized trading products. We’ve spoken about it for seven years, but the most important deadline is approaching in September 2022. UMR is a key catalyst for the buy-side having to solve for product convergence.
MM: Also, after the events of March 2020 clients are looking for additional sources of liquidity and that has continued as a theme.
SFM: Does BNYM have an offering in the convergence space?
BK: This is a portfolio of capabilities across margin management, liquidity management, collateral management, securities finance and transformation, all rooted in data. Clients have the choice of what data do they need, do they gather it directly or via external vendors, then how do they want to execute. If they choose that last step with BNYM then we need to know their full range of financial resources in order to optimize collateral across financing and segregation for OTC derivatives.
MM: This is not new business. We have offered this as a suite of different products for a long time but just haven’t branded it. The growth helps both our clients and ourselves by diversifying the counterparty base and lowering concentration risk.
SFM: Is this part of the Peer to Peer conversation or something different?
BK: Product convergence is a big part of the peer-to-peer story. For example, we recently worked with an insurance company that wanted to optimize financing across managers. We introduced hedge funds and other alternative liquidity sources to get financing through Cash Release or Reverse Repo with BNYM acting as an agent lender.
SFM: What is BNYM agency lending doing in ESG?
BK: There are three main initiatives currently. First, at an institutional level, as the largest agent lender and collateral agent, and largest custodian, we are linking these services together to allow clients to participate in securities lending that includes ESG principles in an effective fashion. We have a responsibility to deliver on this. Second, we are working with industry bodies to develop ESG standards along with large asset owners. And third, we are developing technologies to deliver transparency and opportunity to manage ESG principles to support good stewardship.
MM: It is important that our clients and the industry know that securities lending and ESG can both coexist and thrive. This is at the heart of BNYM agency lending’s goals in this space.