From the desk of John Arnesen
Consulting Lead, Pierpoint Financial
Last year, in the grip of virtually global lockdowns, the securities finance industry faced an imminent deliverable in the form of SFTR. Sensibly, and to its credit, ESMA delayed the first phase from April to July to allow capital markets participants, captured by the reporting requirements, to embed their new operating structures - a challenge given almost everyone was working in silos at home. At the back of everyone's mind was the following regulation on the horizon, CSDR. Given it is likely more far-reaching, thankfully, its launch date was also delayed by 12 months and may be subject to change over mandatory buy-ins if the feedback from industry bodies in the latest consultation from ESMA is received well. After CSDR, it was thought that the industry could take a collective sigh of relief.
That breath may have to be delayed due to the implications of another piece of legislation, the Sustainable Finance Disclosure Regulation (SFDR). In his communication recently, ISLA's CEO, Andy Dyson, wrote extensively why this requirement's definitions need more clarity. Without rehashing his piece, you can read it here: https://www.islaemea.org/blog/reflections-of-the-ceo-6/
What got me thinking was that regulation is never over, and while it has to take centre stage in a business' allocation of resources, there are many areas in a typical lending programme that require a more industrial solution but never get airtime because a functioning solution has been cobbled together. It's possible that the following have been addressed in your programme-if so read no further, well done! If, on the other hand, you face some of these daily, you are in good company.
In Europe, there is a funds category, Plan d'Epargne en Actions(PEA), popular with savers in France. These funds have strict criteria to invest 75% of holdings in companies headquartered in an EC member state or within the EEA to comply with France's favourable tax agreement. In return, investors receive a tax exemption for dividends and capital gains.
When these funds enter a lending programme, the 75% maintenance of European stock can fall below the threshold quite easily if utilisation is healthy. This requires active management of European assets on loan vs custody holdings despite the argument that 'on loan' is still part of the funds' holding. It will require a daily calculation of custody, on-loan and returned positions, and ideally, a block on the trade entry screen to protect the 75% requirement. At face value, this shouldn't appear too onerous to build a robust, automated solution, but I wonder how many control this instead via a macro they have built on the trading desk?
Here is a more sticky problem. A beneficial owner with multiple agent lenders should, in theory, track collateral holdings for any breach of the 5% disclosure threshold in the same way they are obliged to report on their long positions. It isn't enough for agent lenders to set their own threshold, albeit sensible, when it is quite feasible that the total collateral held in any given stock could exceed 5%. Some will argue that collateral is temporary and is not subject to reporting, and that would be fine if all collateral were pledged, but it isn't; title passes, and there is no way around it. If in doubt, hold equity collateral over the record date and see who receives the dividend. This assumes you open collateral accounts in the name of the underlying beneficial owner.
So how do you solve for this problem? Agent lenders can’t share collateral holdings with each other, but they could report to an approved third party. The appointed entity could aggregate all collateral positions and report to the beneficial owner. Perhaps there aren't enough beneficial owners that fall into this category to make it worth someone's while, but I can think of a couple, had one as a client and I worried about this scenario.
The last thorny issue is regulatory. What does it really mean to be subject to best execution under MiFID II in securities lending, and equally important, how do you demonstrate it? I wrote on this subject in November 2019, here is the link, and I wonder if anyone is genuinely comfortable with their approach or has ever been subject to a regulator's audit? I hazard a guess that a regulator would find it equally perplexing to examine compliance with this requirement in a measurable way.
The list of items that need a solution or a better process number far more than my musings here. As investors increasingly embrace the concepts of sustainability and climate change, the demands on securities finance will necessarily increase to embrace these requirements, however they present themselves. As an industry, we tend to think about voting rights and how to protect them, but I think it goes far beyond this into areas not yet developed or even considered.
The good news is this.
The pandemic forced in-person conferences and product updates onto Zoom-based, online webinars, giving service providers a greater audience than typical. I have attended far more events, almost entirely free-of-charge in the last year from the ease of my dining room, and from a far wider variety of entities from FinTechs to trade associations and even free-to-attend FT webinars, I have been genuinely impressed and would like to share a few observations.
Firstly, there are no contrarian views within the securities finance community that technology application should primarily establish standardisation in non-competitive functions. How this should be achieved and governed is perhaps still open for debate, but making progress on this is possible now. Secondly, outside of the world on which we are fixated, there are numerous examples of artificial intelligence, machine learning, natural language processing, tokenisation and distributed ledger technology in use today. The number of FinTechs engaged in the payments sector is alarmingly numerous. Thirdly, securities finance service providers, FIS, IHS Markit, Broadridge, Pirum, Equilend, to name those whose webinars I attended, have made significant enhancements to existing functionality and are all engaged in developing new products or tools to reflect growing demand from their clients. A locked-down, somewhat captive audience has been one unintended but positive consequence of the pandemic for these providers to get their message across and significantly update the industry on what is available. Then there is a small army of FinTechs out there that probably have a solution for some of the examples I gave earlier or, at least, a way to approach it differently but still produce the desired outcome. Securities finance is on the cusp of a change in operating methodology. Some of that will require collaboration between participants, championed by representative trade organisations as the rallying cry. Other aspects will be achieved by adopting and applying the technology and tools that are available now.
What is apparent in all of this, at least to me, is that there is no time like the present to strengthen the functionality of existing programmes in anticipation of a wholesale technological change already underway.