The restrictions new regulation is placing on financial institutions is creating potential opportunities in the securities lending and repo markets for sovereign wealth funds and asset owners. In a Q&A with DerivSource, James Day, Head of Securities Finance for EMEA at BNY Mellon, explains how sovereign wealth funds are well positioned to benefit from the securities lending market today. Listen to the related podcast.
Q. Looking at projections for increased activity first, do you foresee sovereign wealth funds will be increasing their securities lending activity in the next several years? And if so, to what extent?
A. In a joint study with the Official Monetary and Financial Institution Forum (OMFIF) we surveyed two dozen sovereign wealth institutions between April and July of 2016. The institutions collectively hold $4.74 trillion dollars of assets under management and 75% of them were interested in increasing their securities lending activities.
Today we’re witnessing an increased interest from sovereign wealth funds in lending programs, with those already participating expanding their guidelines.
Securities lending is a reliable source of revenue in this low-yielding environment. In some instances, the lending return from a specific asset can exceed the yield on the underlying asset, especially given negative interest rates in certain jurisdictions.
Collateral and counterparty flexibility have a bearing on the amount of revenue that can be generated from an asset. As the natural holders of cash, some sovereign wealth funds are exploring ways to deploy this cash through various funding structures.
As banks move away from balance sheet intensive activities, this is creating opportunities for sovereign wealth funds to increase their activity in the repo market and through peer-to-peer financing opportunities, especially in the Middle East. This is a trend we expect to continue.
The recent fall in the oil price has prompted sovereign wealth funds to look closely at lending opportunities. The extent to which sovereign wealth funds expand their activities will depend on how they address counterparty risk, legal obstacles, regulatory barriers and limited secondary market liquidity.
Q. So why are sovereign wealth funds well-positioned to benefit from the securities lending market?
A. The new rules implemented since the financial crisis aim to increase the ability of financial institutions to deal with future market constraints. The rules require banks to hold large amounts of liquid assets to minimise liquidity crunches in times of stress. There is a narrow definition of the assets considered sufficiently liquid for the regulatory purpose and this includes cash, central bank reserves, US and other top-graded government securities, and a certain amount of top-graded corporate debt.
Banks are required to hold sufficient amounts to cover their total net cash outflows over a 30-day stress period. Banks are also required to have enough net stable funding to cover at least 100% of their liabilities for a one-year period. Regulatory requirements have increased cost across balance sheet intensive activities.
Meanwhile, central banks’ quantitative easing policies, which are designed to pump liquidity into the market through extensive bond buying programs, have contributed to a global shortage of safe assets at a time when demand is rising significantly.
Sovereign wealth funds are well positioned to benefit from securities lending as they are not restricted by the stringent rules on capital and leverage ratios. They are also large holders of government securities which they can make available to the securities lending market. Sovereign wealth funds have the access to funding that enables them to provide financing, for example through repo transactions, that can be costly for banks.
Q. How does securities lending and repo activity complement sovereign wealth funds’ investment strategies, and what value is this likely to add?
A. Sovereign institutions are hungry for yield and this is become more difficult to source in the current low interest rate environment.
Liquidity is viewed by 95% of the respondents to the OMFIF survey as ‘important’ to ‘very important’. Low yields on high quality assets are pushing investors into markets with greater exposure to liquidity risk when monetary conditions or market sentiment changes.
Regulatory changes are reducing overall market liquidity, causing banks to step back from intermediation. Non-bank financial institutions are filling this space, and generally trade in smaller amounts;are less well capitalised; more information-sensitive; and hold positions for shorter terms than the sell-side institutions they replace.
This creates a greater risk of price instability in times of market stress. Access to capital and financing is key to avoiding financial shocks. Sovereign wealth funds’ activity in the funding market, both through repo and securities lending, should improve market makers’ ability to finance long inventory and cover short positions.
As holders of high quality liquid assets, sovereign wealth funds can lend tothem in return for lower grade assets, such as equities and corporate bonds, improving the liquidity of the underlying capital assets as a result.
Q. Looking at the wider market factors. Can securities lending mitigate the effects of low interest rates and geopolitical uncertainties on investment returns?
A. Regulatory requirements pushing banks to hold high quality liquid assets, coupled with central bank bond buying programmes removing high quality liquid assets (HQLA) from the system, is increasing demand to borrow HQLA. As large holders of these assets, sovereign wealth funds are in a good position to capitalise on this demand.Well thought out collateral and counterparty guidelines, and good term lending structures for lending HQLA, can enable sovereign wealth funds to earn greater yields than those achievable on the underlying asset.
Collateral is becoming an asset class in its own right and starting to influence investment decisions.
Q:What regulatory reforms do you think they need to be aware of with regards to securities lending?
A. There are a number of regulations that, while not directly impacting sovereign wealth funds, have implications for the wider market. The sovereign wealth funds we have spoken to said they have felt the biggest regulatory impact from the introduction of Basel III, due to its focus on leverage and liquidity.
The liquidity coverage ratio (LCR) requires banks to hold sufficient high quality liquid assets to cover the total net cash outflows over 30 days. Meanwhile, the net stable funding ratio (NSFR) imposes longer term funding requirements on banks based on asset quality and maturity profile.
The supplementary leverage ratio (SLR) is intended to be a backstop to the risk-weighted capital requirements and limit the amount of leverage that a banking organisation may incur as a blunt, non-risk-based measure.
The combination of these three regulations is having a number of effects, including imposing longer-term funding requirements based on asset quality and maturity profile. This is driving the demand for evergreen and term funding, and increasing the use of borrowing structures which necessitate greater retention of unencumbered HQLA for banks while penalising the use of cash collateral.
Sovereign wealth funds that have flexibility in their collateral schedule to accept a lower grade collateral, such as equities, are prepared to engage in term structures and are well-positioned to capitalise on the opportunities presented in the market.
Future regulation that will impact the market is the introduction of SFTR (Securities Financing Transactions Regulation). The European Commission wants to increase the transparency of securities financing transactions which are not covered through other regulations. Securities financing transactions include repurchase agreements and securities lending activities.
The regulation applies to all transactions conducted within firms established in the EU, regardless of where the individual branch is. This includes EU branches of non-EU firms, and any securities financing transactions where the securities used are issued by an EU issuer or an EU branch or firm. These transactions must be reported to an EU trade repository.
Regulation will add a significant overhead to clients participating in securities finance transactions and could lead to some counterparties withdrawing from the marketplace, creating further opportunities for sovereign wealth funds to participate.
About James Day
James Day is Head of Securities Finance in EMEA for BNY Mellon Markets. He is responsibility for leading the strategic direction of BNY Mellon’s securities lending business in London and the Europe, Middle East and Africa region. James has 20 years of experience in the securities financing industry and was a board member of the International Securities Lending Association, and sat on the Securities Trading Committee at the Association for Financial Markets in Europe.
Prior to joining BNY Mellon, James was an Executive Director and Global Head of Stock Loan Sales and Marketing at UBS. Previously, James progressed through a series of leadership roles with Barclays Capital where he was head of equity financing and head of execution in EMEA and Asia.