Securities finance specialists reflect on market performance in Europe over the past 12 months, and consider the impacts of a potential T+1 implementation in the region, general elections, and how market trends are shaping firms’ development strategies
Panellists
Julien Berge, Head of Fixed Income and Repo, CACEIS
Andrew Geggus, Global Head of Agency Lending, Securities Services, BNP Paribas
Joseph Gillingwater, Global Head of Fixed Income Securities Finance Trading, Northern Trust
Matthew Neville, Managing Director, EMEA Head of Agency Lending Trading, State Street
Rickie Smith, Agency Securities Finance Product Management, J.P. Morgan
Matthew Trickett, Agency Securities Finance Trading, J.P. Morgan
Olivier Zemb, Head of Equity Finance and Collateral Management, CACEIS
How do you assess the performance of European securities lending markets over the past 12 months?
Julien Berge: Over the past 12 months, markets have experienced a bumpy ride, with strong returns up to May 2023 followed by a slow but steady decline. This decline has impacted revenues globally, resulting in a 20 per cent year-on-year (YoY) decrease.
The biggest impact can be seen on equities, corporate bonds and convertible bonds, due to low activity on corporate actions. Additionally, the continuous rise of equity indices, stable interest rates, and struggling inflation, have all contributed as well. This situation has led to a scarcity of specials and a decrease in general collateral (GC) balances, as the need for collateral diminishes with the ongoing upward trend of indices.
The increased value of cash collateral has also limited arbitrage opportunities.
On the other hand, ETFs and high-quality liquid asset (HQLA) returns have remained stable and market participants continue to focus on macro hedging and liquidity coverage ratio (LCR) requirements.
Andrew Geggus: The performance for the region has been mixed. We have seen a decrease in lending revenue across European equities driven by a reduction in conviction on the short end, as well as a decrease in general balances as risk-weighted assets (RWA) constraints are forcing prioritisation of capital deployment. On the reverse side we have seen increased flows in euro corporate bonds as demand has increased broadly across the industry and our supply to the market has likewise increased.
Lastly, the HQLA government bond space remained strong, particularly in the structured longer maturity trades. We have seen some spread compression. However, this has been offset by longer duration transactions and widening collateral parameters.
Joseph Gillingwater: The MSCI Europe index recently hit an all-time high, with a hard landing recession seemingly evaded. This has resulted in a decline in securities lending activity, with softer short side conviction limiting activity in EMEA. The long hedge fund bias has increased borrower internalisation levels and created a glut of broker-to-broker financing, with attractive swap pricing for borrowers covering shorts synthetically. Borrowers therefore have more cost-effective, alternative routes to cover shorts versus a physical borrow. New specials remain scarce across all European markets with a lack of broad sectoral themes, corporate events and IPOs.
Robust demand has remained in place for highly-rated sovereign debt, mainly core issuance from Germany, France and the Netherlands. Absent specials activity, and with the recent equity rally, these are typically sought in term upgrade trades, and driven by liquidity ratio and regulatory capital requirements. The specials space has been relatively benign as central banks telegraph economic policy and enact quantitative tightening, subsequently shrinking their bond holdings and pushing assets back into the street.
Matthew Neville: European equity performance has been softer than previous years. Markets have rallied and hedge funds have been largely long positioned, enabling prime brokers to internalise more of their order flow. In addition, the netting benefits of total return swaps (TRS), along with expensive cash financing, have encouraged primes to borrow cheaply synthetically, so in turn demand for agent lender supply has been adversely impacted.
That said, high interest rate pressure on commercial and retail finances has led to good returns for clients lent across the real estate, retail, travel and auto sectors.
Demand for HQLA remains robust, particularly on upgrade and in term. Given the magnitude of central bank targeted longer-term refinancing operations (TLTRO) repayments, we have seen a marked increase in borrowers looking to fund investment grade corporates versus US Treasury and core European government bonds.
European sovereign specials have declined given the ample liquidity issued by central banks and the Debt Management Office (DMO).
Credit has performed notably well given higher financing costs over the past 12 months, and hedge funds have looked beyond the traditional asset classes to generate alpha. Utilities companies, such as Thames Water, have been particularly in demand.
Matthew Trickett: With global stock markets only knowing one direction — record highs — the past 12 months have seen major swings and challenges to the SBL industry. With valuations soaring and muted volatility, the long bias has now manifested itself into every asset class. Even the resilient emerging market debt has seen the volume of specials reduce. All of these factors have contributed to the significant headwinds on our revenue opportunities, especially in Europe compared to the other continents. Short demand has been lacklustre as many companies maintain strong earnings, and we therefore grew accustomed to the idea that inflation has not yet been fully reined in. Prices reaching these records have naturally put significant strain on the balance sheet and so the need to optimise and finance this area has been one of the peaks of our focus.
In which European markets, both by jurisdiction and asset class, do you identify strongest opportunities for growth of your lending business?
Geggus: We see opportunity across all asset classes in Europe. We continue to see the credit space growing in activity, which matches off nicely to our growth in lendable base. But we also see potential for some rebounding in the European equity market as conviction increases on shorts, which in turn can drive some special activity.
For European government bonds, the real opportunity is for clients who are willing to go down the credit curve in terms of collateral, and who are willing to enter longer term transactions, which enable borrowers to benefit from a regulatory capital perspective.
It is worth keeping an eye on the basis swap, as we start to see rate cuts across jurisdictions, we may see an increase in activity in this space.
Neville: State Street’s Financing Solutions division in continental Europe is in growth-mode.
Regulatory pressure, sharpening of post-Brexit requirements and the expiry of exemptions are forcing market participants in Europe to review their operations. State Street’s EU entity is well positioned to assist firms implement compliant lending programmes.
In addition to our presence in Italy, Germany, the Netherlands and Switzerland, we have become significantly more present in other markets across the EU over the last two years.
We have expanded the team’s footprint in Europe under Christian Schuetze, and are having tremendous success converting the pipeline, growing our client base and increasing supply for our trading team.
We are also focused on enabling lending in the Gulf Cooperation Council member states, where securities lending is becoming an important contributor to efficient capital markets.
In terms of specific asset class demand, we envisage a continuation in demand for HQLA upgrades and credit. We hope to see an increase in corporate activity in equities when central banks begin their much anticipated reductions in base rates.
Trickett: Our focus on the Middle East and North Africa (MENA) region will remain a priority as we recognise the significant growth and potential opportunities it offers. We see the region swiftly moving to become an established SBL market, as they mainstream facilitation of short selling and so see trading volumes increase. We expect more M&A activity in the equity space, further announcements of delistings from the London Stock Exchange (LSE) and funds looking for exposure via broader asset classes. We have seen considerable growth within the retail aggregator pools and expect this to continue as the diversification of the lending pools allows the industry to benefit from the expanded depth and breadth of supply.
A key focus in this space is the ETF portfolios entering the lending market. On the collateral side, we think there will be further strides in tokenisation, and the eligibility to use these assets to safeguard a fund’s liquidity while enhancing market resilience during turbulent times.
Olivier Zemb: If we still consider the UK as a European market, UK equities scripts are already strong and could further strengthen in the future.
Polish and Greek equities are experiencing growth in the lending market despite less favourable macroeconomic conditions.
In TARGET2-Securities (T2S) markets, where Central Securities Depositories Regulation (CSDR) penalties apply, the need for fail coverage may lead to increased revenues for lenders as penalties could rise significantly.
HQLA investors seeking yields during the low interest rate period, are now considering swapping low grade assets for government bonds on a term basis, creating opportunities for lenders with the right collateral profile.
In the corporate and converts sector, a decrease in interest rates could lead to directional shorts and arbitrage opportunities that will potentially increase volumes and fees for lenders.
What pressures and opportunities have recent regulatory initiatives created for your securities lending business?
Rickie Smith: Differing approaches taken by local regulators in implementing EU directives have proven challenging for the industry as a whole. This is evident through regulations focused on sustainability, whereby a divergence in scope and certain disclosure requirements have caused variations in implementation.
Prudential regulations such as Basel III Endgame pose ongoing challenges, impacting capital requirements and RWAs, potentially elevating operational costs. Generally, compliance costs, spanning technology investments, vendor expenses and operational model enhancements are increasingly evident as observed through the implementation of CSDR and Securities Financing Transactions Regulation (SFTR), all contributing to an increase in the cost of doing business.
Opportunities emerge at both the market and individual firm levels, driven by increased transparency, market standardisation and innovation. From the market level perspective, regulations such as CSDR and SFTR have fostered industry collaboration in setting optimal standards and best practices. At an individual firm level, employing a robust regulatory and oversight framework has empowered our business to offer compliant solutions to our clients in meeting their regulatory obligations.
Zemb: For T+1, the transition has created uncertainty for clients who require asset servicing companies to provide information and assistance. While there may be challenges during the T+1 implementation, internal reallocations will prove to be far more effective than recalls.
Overall, instead of halting US asset lending, beneficial owners should consider expanding their lending programmes to generate additional revenue streams in the long-run.
For Basel III Endgame, there is a focus on reducing pressure on RWAs by exploring optimisation strategies such as pledging, CCP, under-collateralisation issues, and establishing ratings for non-rated entities.
Neville: CSDR enabled the industry to focus on improving pre and post-execution workflows to minimise failed trades and related fines. In general, this led to improved pre-matching and enhancements to vendor solutions, which provided greater visibility for identifying and solving persistent themes, thereby enhancing operational efficiencies.
Market participants are now focused on preparing for Basel III Endgame and solutioning to minimise its impact on financial resources.
There are strong opportunities for agent lenders and beneficial owners who are able to trade via a broad range of capital efficient structures to meet the differing demands of borrowers. Consequently, we have focused our resources on various clearing and pledge structures which will complement well-established solutions that cater for low risk weight directed demand. We have also been educating eligible clients as to the benefits of clearing and pledge, given the possible impact on utilisation of their inventory as borrowers become more sophisticated in their targeting of supply aimed at minimising the use of capital.
As we look ahead, the industry has plenty of regulatory-driven initiatives to grapple with. T+1 in the UK and Europe is hot on the heels of implementation in North America, and recent industry vendor outages have brought the Digital Operational Resilience Act (DORA) into the spotlight.
Gillingwater: We continue to observe ongoing changes to the regulatory landscape which impact the securities lending industry. However, these have largely focused on enhancing transparency, agility, and technology, to improve efficiency and resiliency in the industry. For example, the adoption of SEC Rule 10c-1a in the US is aimed at enhancing transparency by increased disclosure requirements, transaction reporting, and compliance oversight, with a requirement for security level transaction reporting.
In terms of opportunities, capital-efficient trade structures remain in focus as Basel III Endgame approaches and counterparties look to optimise RWA consumption. Borrowers may consider ‘smart bucketing’ clients based on RWA, with the most efficient asset owners benefiting from increased flow. This will be problematic for less efficient clients to distribute their available supply, initiatives such as alternative pledge structures, central clearing, and alternative forms of indemnification are being developed and implemented to help offset these potential challenges.
Geggus: In Europe, we experienced a small break from implementing large scale regulatory reforms. However, there is always something on the horizon. We are waiting to see the impacts of the second phase of CSDR. Overall, settlements appear to have improved in the market, but perhaps not to the level that market participants and regulators were hoping for.
This is important for the industry as settlement efficiency is being used as a key metric by regulators, and with the ambition of shorter settlement cycles, it will be necessary to vastly improve the settlement rates. The pressure is there from the regulators in the form of penalties, but the opportunity for the market is clear to see. If all industry participants can reduce the manual intervention, emails, and escalations on fails, then a greater percentage of time can be focused on business growth and higher value tasks.
The UK government has agreed that the country should move to a T+1 settlement cycle. How is this set to impact the rest of Europe in terms of its infrastructure, and how far behind is the EU in following suit with a shorter settlement cycle?
Neville: The US move to T+1, and the plans for the UK to follow suit, have already expedited action from the EU. The European Securities and Markets Authority (ESMA) has undertaken a public consultation on T+1 and committed to report back by January 2025. While the UK is recommending transition to T+1 by 31 December 2027, ideally the UK would want to coordinate with the EU to avoid any period of misalignment.
The recently published Accelerated Settlement Taskforce (AST) report highlights several challenges and impacts for the rest of Europe, should the UK move to T+1 ahead of the continent. For example, there may be an increase in costs for funds containing both UK and European securities, which may discourage investment in certain funds, while separate liquidity pools may be created where securities are multi-listed.
Geggus: Firstly, the EU will not be far behind, so we can consider T+1 across the UK and the EU in a similar vein. The UK and EU will benefit from the fact that the US has moved to T+1. The US market has larger volumes than the others combined, therefore any previously unidentified consequences will likely be addressed ahead of time. One consideration that is clear, is that the speed of data transfer will be vitally important to ensuring minimal impact to the time we have to get items settled.
There is an issue for securities lending agents that a lot of sales that are executed at market close, but do not feed their lending agents systems till many hours later, or potentially even the following day. There is no need for this to be the case and it should be possible to get sales executed at market close, and feeding through straight-through processing (STP) within a few hours maximum. This will require some changes to the recall process and agreements with borrowers on how this will be managed, but I expect the impact to be limited and the market to adapt in quick order.
Berge: Following the move in the US, it is crucial for all markets, including the UK, to transition to a T+1 settlement cycle sooner rather than later. We are confident that participants have taken the necessary steps to update their systems, processes, and infrastructure to prepare for this change. However, the only potential consequence we anticipate is for lenders who do not engage in bulk transactions and are unable to internally reallocate their positions.
Gillingwater: Any move by one of the major world markets to shorten its settlement cycle will have ripple effects. Markets around the world will no doubt monitor the move by the US to T+1 settlement and choose if and when, over the coming years, to align settlement cycles, out of convenience if nothing else.
Making the move is not straightforward, and there are myriad considerations for regulators, not least of which is creating an implementation pathway that gives asset managers and owners, and everybody else who contributes to the orchestrated ecosystem of a successfully settled trade, sufficient time to adapt.
That said, the UK can make a decision to move unilaterally. The UK has a single currency under a single regulator and a single national framework. The EU is more complicated. Change at EU and European Economic Area (EEA) level needs to consider multiple exchanges in multiple jurisdictions, multiple currencies and timezones (Finland to Portugal to Ireland) and the supranational regulatory versus national frameworks perspective. Given the proven time-to-implementation of past EU regulatory change, the industry might expect T+1 to take some years longer in the EU and EEA.
Smith: In the UK, the establishment of the Accelerated Settlement Taskforce aimed to explore the feasibility of transitioning to a T+1 settlement cycle. In March 2024, the Taskforce chair released a report proposing a transition to T+1 by the end of 2027. Recognising the importance of conducting further analysis across the trade-to-post-trade lifecycle, and learning from the US experience, a technical group was formed to determine the scope, methodology, and timeline for the transition. This technical group is expected to deliver a comprehensive report by the end of 2024.
Meanwhile, in the EU, ESMA is analysing the possibility of T+1 and is due to publish a recommendation by the end of the year, which will include a date should a move be proposed. The impact on the EU is more intricate than the UK, as it necessitates coordination across multiple markets, financial market infrastructures and regulatory frameworks. Nonetheless, synchronising plans and timelines with the UK could offer significant benefits to both jurisdictions if achieved.
What investments and adaptations to working practices have you made to sustain and grow your European securities lending activity in this environment?
Geggus: We have invested heavily over the past few years and will continue to do so to help the growth ambitions of our product, not just in Europe, but across the global business. One key area focuses on improving the level of automation and efficiency across the business. We have made a large effort to move to as little manual intervention as possible across the lifecycle of a loan, which in turn will help to ensure the business is well placed for the global move to shorten settlement cycles.
In addition, we have built a new client portal with reporting and functionality, allowing clients to have a more hands-on experience in their securities lending programmes if they so wish. This is being rolled out in 2024 and we expect the functionality to continuously improve each year, adapting to what our clients want to see and do.
Another notable area of investment for BNP Paribas has been in its people — we have bolstered the team globally and have made some impressive additions to the team in the past 12 months. We want to match off utilising technology to enhance automation and efficiency, coupled with the best people to manage our relationships with clients and borrowers and working to improve BNP Paribas’ offering.
Smith: As firms prepare for the forthcoming implementation of Basel III, the anticipated capital pressures have led to a growing demand for trading structures that offer enhanced capital efficiency. Borrowers are increasingly seeking solutions such as pledge, derivative-based financing, title transfer pledge-back, and CCP lending models. It is crucial that our lending product is aligned to meet this demand and continue to support the distribution of our underlying clients’ inventory, ensuring we effectively address the evolving needs of our borrowers.
As client behaviour and expectations of a lending agent change, we are seeing an increased focus from buy side firms looking to outsource certain functions to gain operational efficiencies. In response to this, we are enhancing existing financing related services — for example through the expanded coverage of our Cash Investment, Liquidity Generation and Collateral Transport products — and collaborating with other product lines, such as middle office and collateral management, to provide our clients with a comprehensive service offering across the J.P. Morgan franchise.
Neville: State Street continues to invest in our securities finance technology stack across the trading lifecycle.
From a distribution perspective, we recently launched our Venturi agency lending portal, which enables borrowers connectivity to source equity and fixed income securities directly from our lending programme via an API or web-based graphical user interface (GUI).
We are also committed to adding our supply to additional third-party distribution platforms this year to simplify borrower connectivity to client inventory.
We continue to invest heavily in a multi-year programme to upgrade our trading and operations platforms, as well as our post-trade architecture and capital efficient structures, including clearing, reinforcing our commitment to servicing clients in our programme for years to come. Furthermore, investment in real-time processing of recalls to meet the tighter deadlines introduced for T+1 in North America will be extended to all European markets to facilitate timely settlements.
Gillingwater: Segregated collateral schedules continue to be popular and a common theme with regulatory capital or funding efficiency as the main driver. This is largely in the form of agent lenders looking to support capital efficient structures, for example, the Global Master Securities Lending Agreement (GMSLA) pledge for non-US borrowers or low RWA buckets.
Additionally, we continue to actively grow loan volume for those beneficial owners with flexibility and willingness to transact outside the typical indemnity. This is often against a broader collateral profile, for example, convertible and corporate bonds, asset-backed securities (ABSs) and collateralised-loan obligations (CLOs), and lower grade equities, providing borrowers with greater funding flexibility to put idle assets to work, and a significant revenue uplift for our clients.
Zemb: The automation process, particularly for recalls, involves integrating and generalising sales intentions, as well as automatically reallocating and recalling assets.
To optimise RWAs, it is necessary to calculate the cost and revenues for each trade in order to perform a granular analysis of collateral, haircuts, assets lent, and counterparties to calculate the break-even fee. The objective is to open up new markets to maximise clients’ revenues.
Increasing communication with clients and the CA department is crucial to obtain intentions for each event and ensure that returns are optimised.
What expectations do your clients have from you as a service provider in supporting their commitment to sustainable lending and borrowing? Have recent market conditions and geopolitical stresses had an impact on demand for ESG-compliant lending solutions?
Zemb: Our clients have been under pressure in recent years due to ESG-related issues, which has even led them to question the usefulness of maintaining or implementing a securities lending programme for their portfolios. As a service provider, we have adapted our offer to ensure that this activity in no way impacts asset owners who are in compliance with the new rules. Current market conditions and geopolitical strain have not been identified as specific catalysts, but rather parameters integrated into the ESG management framework.
Neville: ESG continues to be a focus for many clients in Europe, however, there are wide-ranging opinions as to what ESG means to each of them.
Clients do not generally intend to make structural changes to their lending programmes. Some want to ensure they maintain control of their voting rights, which can be exerted through utilisation of our proxy recall process. Others enquire as to the impact on utilisation should they wish to restrict certain securities from their collateral profiles. However, collateral alignment with ESG principles seems to be less of a concern given collateral is a risk-mitigant and would be liquidated in the event of a default.
We also have clients who would like more transparency into where their securities are lent beyond the first borrower and for what purpose they are borrowed, both of which the industry is unable to offer today.
On the whole, we are beginning to see clients more regularly involve representation from their responsible investing teams in securities lending related discussions, and we anticipate this trend to continue.
Geggus: Our approach to ESG and sustainable securities lending solutions is to work with our clients to understand their needs fully and help them achieve these goals. We do not see a one-size-fits-all solution, therefore we are approaching it from more of a customised standpoint across the full investment landscape.
How do you assess the outlook for European securities lending markets for the remainder of 2024 and into 2025?
Gillingwater: Overall demand remains steadfast for European securities lending activity. New opportunities continue to present themselves through name specific trading and general collateral activity. As central banks start to ease monetary policy we should see new opportunities arise, versus both cash investments and in non-cash collateralised loan activity.
With specials activity softer across the globe, Northern Trust continues to seek new initiatives to drive revenue, proactively distributing client supply, optimising term structures and utilising wider collateral buckets where appropriate. More broadly, we expect securities lending will continue to be a positive revenue generator for our clients throughout 2024 and into next year.
Trickett: In 2024, voting, diversification and technology will take centre stage. A record share of the global population is expected to participate in voting this year. As elections approach, government spending typically rises, and central bank policies often become more accommodative, leading to increased economic uncertainty. This macro focus will shape the remainder of the year.
Additionally, the reliance on technology and the inefficiencies that automation can mask have been brought to the forefront early in Q1 2024. Looking ahead, we anticipate a broader adoption of platforms and a convergence of technology, operational and trading efficiencies.
Berge: The outcome will be influenced by the actions of central banks. We anticipate that the situation will remain relatively stable for the rest of 2024, with high returns expected on HQLA and consistent revenues from other asset classes.
In 2025, there may be a resurgence of volatility and arbitrage opportunities leading to increased revenues.
It will be essential to keep a close eye on a possible spread of T+1 ‘contagion’ to other markets and potentially higher CSDR penalties.
Geggus: Not without challenges, but there are plenty of opportunities out there as well. At BNP Paribas, we are in an exciting growth phase, and where many are pulling back, we are investing. It is an exciting time to be part of the business, and we are seeing a global buoy of activity, including across European securities lending markets.
Neville: As previously highlighted, as we approach Basel III Endgame we expect borrowers to direct more of their demand towards clients who represent a lower drag on capital. This will inevitably mean borrowers evaluating clients based on a range of factors such as entity type, jurisdiction based on netting enforceability, whether they have approved GMSLA Pledge or alternative pledge structures, breadth of collateral and whether they can lend on term. For some clients who are unable to meet certain criteria, approving their agent to lend for them through a CCP may be a solution, and we expect to see equities being lent through a CCP in Europe later this year.
In terms of markets, European equities are hitting new highs, boosted by expectations of interest rate cuts along with bullish earnings forecasts. Hedge funds continue to be long-biassed, with targeted stock picking on the short side, so short balances are likely to remain subdued in the near term. However, as the cost of borrowing decreases, opportunities for corporate activity may begin to unfold, for example BHP’s unsolicited approach for Anglo American. Additionally, companies with the greatest distressed debt may well look to refinance through stock offerings.
In fixed income, given a series of rate cuts by the European Central Bank and the Bank of England are priced in from June onwards, we do not expect to see too much of an impact to lending markets other than some more stability a little further along the curve. We still expect to see demand in the short end core countries and caution in the long maturities. TLTRO repayments will continue and finalise in December 2024, so we will continue to see demand for investment grade (IG) upgrades. No real volatility is expected in the GC markets from a TLTRO roll down until excess liquidity in the system gets to around €1.5-2 trillion, which is some way off yet.
