Updated: Jul 17, 2020
From the desk of John Arnesen
Consulting lead, Pierpoint Financial Consulting
Could this be a lucrative time for securities finance?
Many have subscribed to our daily round-up of news stories, aimed at providing you with articles you may be too busy to read while keeping the lights on. In searching for interesting pieces, you will appreciate that I spend a lot of my day reading article after article. (If you haven’t signed up yet but would like to, go here)
Not wanting to bombard readers with continually horrendous negative stories, I try and find a balance between the worst of news and more encouraging and upbeat pieces. It can prove challenging as in reality there isn’t much in the way of good news. Economic output figures have become somewhat mind-boggling when projecting a global GDP contraction of -3% in 2020 with advanced economies projecting a -6.1%, according to the IMF.
At the time of writing, the US has just reported its first quarter, annualised GDP figure of -4.8%, and a March retail sales figure fall of 8.7%. Then there is the human cost in terms of lost livelihoods with the UN’s International Labour Organization (ILO) estimating that global working hours in Q2 of 2020 will be 10.5% lower than Q4 of 2019. That is the equivalent to a loss of 305 million full-time jobs! It gets worse, the ILO estimate that of the 2bn people working informally around the world, roughly 1.6bn have suffered “massive damage to their capacity to earn a living.” The likely rise in poverty will be unimaginable.
This is and will be unlike any downturn in the past as its economic causes are self-inflicted, albeit for sound reasons and reach every sector of the global economy. Given that breadth, the shape of the recovery is hard to predict (e.g a ‘V’shape, ‘U’ shape, ‘L’shape – there is even an ‘I’ shape contemplated). Still, it is clear that the damage done to businesses, large corporations, and individuals will present itself in a variety of ways and will undoubtedly change investor behaviour. The impact on bank reporting for Q1 2020, year-on-year is most notable for the sensible increase in loan loss provisions. US and European banks are likely to book $50bn in provisions for non-performing loans in Q1, 2020. (See chart)
While ploughing through this grim reading, I think about securities finance and the effects the deep recession we have now entered will have on the industry for the remainder of 2020 and beyond. In my experience, securities lending is a resilient product that expands and contracts in tandem with changes to demand in any market conditions, including recessions, however deep. Nevertheless, demand from end-users in the form of hedge funds and supply from institutional investors may diverge depending on changes to the risk appetite of not only these sectors but also the intermediaries that service them – prime/brokers, banks, and agent lenders.
Financing desks and/or prime brokers may have a reduction of balance sheet allocation forced upon them as happened after the Global Financial Crisis so will need to become even more efficient in borrowing activities and to manage regulatory capital consumption, such as the leverage ratio. If this does materialise, how will beneficial owners ensure their assets generate a meaningful return in the face of potential subdued demand with no real adjustment to supply? Moreover, agent lenders, the typical distribution channel for beneficial owner assets, have few variable costs and are absorbing vast expenditure and resources completing their SFTR reporting project before they tackle readiness for CSDR. The last thing they need is a decoupling of their clients’ lendable assets with borrower demand, a compression in spreads or fees and changes to acceptable collateral, particularly the acceptance of corporate debt in the face of widespread downgrades.
I'm reluctant to draw parallels with the Global Financial Crisis as the drivers are very different, and the emerging economic impact is far more significant. It has already surpassed the prior data set back in 2008-2009. Back then, the securities lending market suffered a reduction in outstanding loan balances by 50% and has never really recovered. Crucially, the decline in demand between 2008 -2009 was primarily driven by a collapse in propriety trading from investment banks, not that of hedge funds. (See chart below.)This proprietary trading halt was self-imposed and emerged before it became embedded in regulation. Are we going to experience declines again – both enforced and voluntary?
In reviewing publicly issued data, there doesn’t yet seem to be any marked decline in fees for the three global regions of the Americas, Europe and Asia for equity loans. On-loan values have increased significantly in the Americas by 9.5% but declined in Asia by 27% over the past month. Not unsurprisingly, over the past month the value of lendable supply has increased globally by 13%, but going forward all of these statistics will be subject to asset price and foreign exchange volatility which remains unsettled.
The fixed income markets have been stable over the same period as demand for Government debt has been steady and consistent for many years now in supporting the liquidity coverage ratio (LCR) needs of borrowers, and this will continue. The past month is when we experienced the full effects of the virtual global lockdown. It appears that the securities finance market continued to operate in a stable fashion on the back of a period in which the VIX reached a high of 82 in March and is now in the high 30s, three times its value at the beginning of the year.
Will this continue? That’s incredibly hard to predict as a lot will depend on changes to supply as investors grapple with what to buy and when, and equally important what, to sell. Given the variety of drivers that lead to a demand to borrow securities, there is enough volatility for the long/short, directional short and Delta One traders in which to sink their teeth. In theory, we could be entering a lucrative period for securities finance participants as long as the supply side can maintain flexibility, including acceptable collateral. It is tempting in these volatile times for lenders to react negatively, fearing an existential threat that may or may not materialise and thereby restrict their ability to generate revenue. At Pierpoint Financial Consulting, we can advise you how best to steer your lending programme through these unchartered waters. Call us on +44 7366 467 127.