Caceis looks ahead

Dan Copin, Group Head of Securities Finance & Repo and Remy Ferraretto, Senior Sales Securities Finance & Repo at Caceis outline some of the key issues affecting the group’s securities lending business.

In order to make sense of our objectives as a firm, it is necessary to consider some of the developments that have impacted securities lending over the last few years.

Market overview

Banks’ constraints in terms of accounting and regulatory ratios have allowed a certain dynamic to be created in recent years. The recurring need for high quality securities as a result of the LCR has made it possible to bring in structures allowing for greater added value.

However, the low interest rate environment has added to the pressure to generate additional returns. On repo, banks are limiting their supply of paper – and therefore liquidity - and significantly downgrading their levels with the objective of managing these scarce resources more efficiently.

NSFR, which enters into force on July 2021 should lead to a few movements in the market, although not to the same extent as the LCR.

In the securities lending space, the coronavirus crisis has highlighted the need to offer clients a better experience, both in terms of reporting and information on what we are doing with their securities.

If we look at trends over the first half of the year in the equity lending segment, it is clear that demand for ETFs continues to increase. With the transfer of investment from active to passive management, ETFs are increasingly liquid and becoming a mainstream asset class for use as collateral.

We have also seen the return of ‘special situations’ which have helped generate extra performance for those funds invested in the right securities during the second quarter of 2021. Last year there was limited external growth due to the economic context and uncertainty around corporate cash flows.

In 2021 we see more corporate actions (M&A, stock buyback, IPO, right issues, convertible bonds) and also more scrip dividends. Notwithstanding a good start to the year, February was marked by a deleveraging of hedge funds with historical low short positions on special names.

On the fixed income side, debt buybacks by central banks over recent months have dried up the funding market. Taking the impact of regulatory and balance sheet constraints into account, the result is a market that is less efficient with reduced liquidity.

There are more trading opportunities in triparty structures due to the need to manage increasing volumes, but financing levels remain very low on account of there being too much cash in the market.

How this plays out over the remainder of the year will depend on how the global economy recovers from the impact of the pandemic and specifically the movement of inflation rates. We have seen some signs of inflation returning, which would of course mean the end of very low or negative interest rates and therefore higher spreads, benefitting fixed income activity.

Key topics

More than ever, ESG is the subject of extensive discussion in the securities lending space as investors seek to invest in sustainable products and to be reassured on the investments they are considering.

We believe that securities lending can meet both lenders’ and borrowers’ specific ESG criteria as long as a strong set of conduct rules are in place. We have held discussions with all market participants and taken part in many roundtables in order to help the industry establish a robust set of sustainability principles for securities lending, the key components of which can be summarised as follows:

• Transparency and ethics
• Service provider selection
• Borrower selection
• Collateral selection
• Voting rights and general meetings attendance

It is important to be transparent throughout the securities lending process, providing dedicated activity reports (positions, collateral received), benchmark reporting, and analysis of the liquidity versus risk approach to securities lending.

For borrower selection, a strict counterparty approval policy based on quantitative and qualitative criteria is vital. When it comes to selecting collateral, lending clients should have the option to exclude securities that do not fit with their ESG policy.

On the question of recalling securities during AGM periods, a recall option enables lenders to vote on resolutions. Another possibility is to set up a quota system of stocks to be recalled - also known as ‘buffers’.

We believe that industry players have a responsibility to contribute to greater understanding and transparency of securities lending as there are misconceptions that can become accepted as fact and have a negative impact on beneficial owners’ decisions to pursue lending activity.

Perhaps the most damaging misconception is that securities lending encourages speculative behaviour and aggressive short-selling. Securities lending is essential for the proper functioning of financial markets as it makes it possible to cover pending or short sales when the latter are authorised and to structure indices or hedging products for investors.

However, we also recognise that management strategies – regardless of how beneficial they may be for the future - cannot be the cause of market disruption by drying up securities lending inventories. 

In terms of regulations

We also feel that steps need to be taken to optimise the efficiency of SFTR reporting. SFTR is the last piece of the OTC product puzzle for trade repository declarations and is an obligation for daily reporting of transactions, associated events, their valuations and collateral exchange.

It imposes major reporting commitments and, even when the lending agent is able to carry a major share of this burden, clients will need to monitor the quality of reporting. SFTR reporting is well established for funds but the onus is on all players to make progress on the collateral reconciliation rate.

CSDR regulation is the next big topic for beneficial owners where the lending industry will have an important role to play. We expect the second phase of the regulation to encourage market participants to borrow securities in order to avoid compulsory repurchase proceedings if settlement/delivery is suspended, which could generate significant negative impacts on their performance.

Technology

Digitising and optimising our tools is an important part of this process, allowing us to rapidly structure and make operational data available to clients. These technological levers (and the flexibility of our structure) make it possible to respond to increasing volumes of requests from clients around the transactions negotiated and best practice processes relating to issues such as ESG.

Our management information system is already helping resolve pending settlement transactions, enabling clients to operate more efficiently and get a head start on upcoming regulation. The growing impact of technology cannot be denied and requires firms to optimise trading tools to keep up with increasingly complex trading activity such as cross-asset structures.

Maximising revenues for our clients is the main purpose of our activity, which implies a strong responsiveness to different market movements through a proactive rerate strategy; optimised communication with clients regarding corporate actions elections; collecting the data needed to establish prices; and offering solutions to customers seeking greater customisation.

Reconciling standardisation of many market processes (SFTR, CSDR) with customised client requests that involve constant IT developments is a challenge.

Where next?

Looking further ahead, there are a number of developments that will affect securities lending over the coming years.

Product life cycles are getting shorter and the market is now mature. From a trading point of view, we expect to see a continual increase in the supply of lenders looking - in an environment of low interest rates - to maximise their inventories and benefit from returns, although overall these returns have been down for all asset classes combined for some time.

The industry is facing standardisation on the trading side due to current regulations and stronger risk approaches following the last financial crisis, which will make it increasingly difficult to innovate in terms of products.

Spreads have been under pressure for quite some time and the interventions during the coronavirus crisis make us think that this situation will not change any time soon. However, in a very competitive environment we need to find new paths of growth for our beneficial owners.

One of the ways in which we hope to achieve this is by optimising tools and processes through greater digitisation. With more flow to manage as spreads tighten, service provider tools need to be more efficient and we will continue to focus on the use of new technologies.

It will also be important to ensure that our organisation remains client-oriented in order to anticipate and support their needs and address any constraints they face. Client interaction has increased considerably despite lockdown restrictions – one of the positive developments to emerge from what has been a challenging time for everyone in the industry.

This article is part of the Global Investor Summer 2021 Magazine, and if you want to find more click here to download the magazine.