From the desk of Roy Zimmerhansl,
Practice Lead, Pierpoint Financial Consulting
What a ridiculous statement to make. After all, the growth in supply has outpaced the increase in demand. A few easy pieces of evidence prove the case. The absolute number of institutions that are actively lending continues to grow. More countries have mandatory company pension fund contributions than ever before, so these funds are structurally designed to grow. Pension funds collectively have more assets on loan than any other segment. Retail funds, including mutual funds and ETFs, sweep up investor money, often fueled by passive investment trends and performance in the period after the Global Financial Crisis 2007-2008. Retail funds have more assets available for loan than any other group. Sovereign wealth funds continue to expand, and proportionately they have a higher percentage of assets on loan than any other segment. I think you get the picture – assets are up and aside from short-term jerks due to the occasional market crash, the figure available for loan has never been higher.
What about demand? Securities lending values on loan reached roughly $4 trillion at its peak in 2007/2008. That dropped by half almost immediately after Lehman defaulted and just short of twelve years later, the figure is broadly the same – around $2 trillion. So, more supply, essentially flat demand, therefore oversupply. Job done, claim debunked, move along, nothing to see here.
Of course, there is more to it. According to some, hedge fund assets under management reached record levels last year. Hedge funds represent a vast array of funds aggregated under a single label and obviously not all funds employ short-selling strategies, but the magnitude of growth almost certainly means short exposure has also increased yet this hasn’t been reflected in the securities lending market, begging the question ‘why?’. At least three reasons spring to mind. Prime brokers have been focused on internalising short-covering, using available long positions rather than borrowing externally. In fact, often, prime brokers create their own supply to meet client needs. Beyond this, synthetics also capture a large chunk of short exposure and are an ever-expanding part of the prime brokerage business.
These three securities lending alternatives are all driven by economics. The cost of capital, the cost of collateral and other factors, along with a healthy dose of regulatory disequilibrium, combine to push physical securities lending from an external party into the position of often being the least favourable way of providing short exposure. Add to that the pseudo-internalisation of some agent lenders satisfying the needs of hedge funds, typically covering general collateral (GC) loans, often labelled as ‘enhanced custody’ or ‘prime custody’, and also the nascent potential impact of peer-to-peer activity and these have a profound impact on conventional securities lending.
If you accept my thesis that there is a broader universe of shorts that elude the grasp of beneficial owners and their agent lenders, the question becomes, how does one recapture some of that lost flow. Let me tell you that you can’t so get over it; it’s gone. Unless there are regulatory or structural changes, I can’t see any way for traditional securities lending to get that volume back. What kind of changes? For example, the removal of distortions for treatment between synthetic and cash positions; the costs involved in collateralisation (for example) become prohibitive; the economics of investment bank self-creation of supply or if there was a dramatic narrowing of hedge fund strategies which meant less trading diversification.
Having said that, we work with individual clients on how they can individually improve their revenue capture for themselves or their clients, but that is at the expense of their competitors and not a wholesale switch away from internalisation/synthetics to physical externally-sourced supply.
Now that’s depressing.
I prefer to be optimistic, so reaching into my magic money bag, what can I conjure up? Rather than go after lost ground which will be difficult if not impossible, I challenge the industry to create new trading demand. I have taught securities lending concepts, principles and practices to well over a thousand people now and they will tell you that I typically say that securities lending is a secondary market practice – reactive to a borrow request or a collateral transformation opportunity, but not a transaction initiator as such.
So, I am not suggesting that somehow lenders can create new demand on their own. However, what can happen is for the market to make the requisite changes that will remove as many barriers as possible for trade execution, reducing unit costs – not only improving the competitive positioning of physical lending, but more importantly facilitate new entrants, new applications or higher volumes of existing usages of lending.
We often and easily focus on automated trade execution and for me, that has always been central to my approach – it’s easier to keep a trade outstanding than get a trade in the first instance. At just about every firm I have worked at, we have understandably focused on trade execution. However, in terms of cost, efficiency and risk management, trade execution is the least important aspect of the business. On any given day, there are more outstanding transactions than new ones, equally meaning that outstanding transaction values are much larger than settlements in one day. As a side note, my firms have often had daily settlement limits so that daily risk was capped. Viewed another way, the costs and risks of managing the book are dramatically higher than building the book.
Despite this reality, investment in risk management is left to individual firms. I’m ok with that, it’s capitalism and eventually, inadequate risk management will result in casualties. Regulatory capital requirements are designed to enforce sound risk management, and bank resolution documents are the living wills that are the fallback in the event risk management fails at a firm.
The primary purpose behind the Securities Financing Transactions Regulation (SFTR) was to provide European regulators with information on a wide range of transactions. The objective is to increase the visibility regulators have into market activity daily, and using this data, improve risk oversight.
SFTR imposes not only cumbersome and minutely detailed reporting requirements but most importantly, this reporting is on reconciled positions and on a daily basis. Waiting until settlement date, hoping everything works out ok is no longer an option under SFTR. Firms captured by SFTR are now or will soon need to be compliant, facing penalties if they fail to satisfy the regulations.
This huge challenge will be met. Inevitably the outcome will be improved efficiency, higher settlement rates and fewer losses due to ongoing transaction discrepancies from dividend/interest substitution payments, fees or corporate action settlements. However, SFTR is a European regulation, what about the rest of the world and the counterparties and transactions that aren’t captured?
The Uncleared Margin Rules (UMR) that cover OTC derivatives are being implemented over an extended period across the world, reducing risk accordingly. Let me be clear that I don’t necessarily want SFTR to be applied on a global basis, however, the focus on timeliness, reconciliation, problem resolution and inevitable efficiency improvement shouldn’t need regulation, the benefits should be obvious. Nevertheless, the daily grind means that our goals are short-term – let me fix today’s breaks, and I’ll deal with tomorrow’s problems tomorrow. But tomorrow never comes, because when we get to tomorrow, it’s back to ‘let me fix today’s breaks …’
Stock market execution moved from handwritten letters instructing purchases and sales through to ‘wire’ transmission and telephone instructions to trading platforms through to the facilitation of high-frequency trading, algorithmic trading, AI and beyond. Each technological change affected the economics of trading, lowering trading costs, giving access to new market participants for new applications and cheaper access for traditional transactions.
I submit that a more efficient, lower-cost, more automated operating environment will follow that stock exchange example of improved application. Think of the transition of a market from not allowing securities lending to it becoming a fundamental market practice. Once that transition occurs, market making is either enabled or enhanced. That improves liquidity. Allow non-resident traders to short sell, attract supply to support that activity and liquidity will be boosted further.
Efficiency and de facto risk reduction can’t help but facilitate greater participation by a wider spread of market participants (some entirely new to market) across both innovative and traditional applications of securities lending. However, this requires a different thought process and approach.
Going back to the title of this blog post – the market isn’t oversupplied, access to it is artificially expensive and operationally cumbersome. Change those dynamics and boost the demand for borrowing.
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