Securities lending participants clearly felt the impact of the recent global financial crisis, which created the some of the most volatile and illiquid markets experienced since the Great Depression. Over this time, lending participants, along with the agents that provide securities lending services, have all watched with a keen eye the factors affecting the market. One of the first questions on many participants’ minds: How strong is the demand for borrowed securities and how might the intrinsic value of investment portfolios change over time? Point of View sat down with Northern Trust’s Jeff Benner, deputy global head of securities lending, Chris Doell, head of North American client relations, and Sunil Daswani, international head of client relations, to gather their thoughts on the current and future direction of the securities lending markets.
Point of View: The global securities lending markets seem to have somewhat stabilized. What does securities lending activity look like today compared to pre-crisis levels?
Chris Doell: What we see today is simply a more “stabilized” marketplace. Keep in mind that securities lending agents like Northern Trust look to add value for clients. We interface with our approved counterparties who are looking to secure short-term access to securities and add value by negotiating the terms of the resulting loan arrangement. In this respect, our role is to capitalize on the intrinsic value of our clients’ securities portfolios by identifying and capitalizing on the strength of demand demonstrated by the borrower community.
In relation to collateral, in some cases, the borrowers post non-cash collateral in return for the securities loaned. In other cases, the securities loaned are instead collateralized with cash, which is furnished by the borrower and then marked-to-market. In those cases, we also look to add value for our clients by investing the cash collateral according to agreed-upon guidelines.
When we refer to today’s securities lending markets as more “stabilized” it is important to put that categorization into historical context. If you look across the industry, securities lending loan volumes are significantly lower than the peak figures seen previously. Data Explorers, a supplier of securities lending and short-selling data and analysis, estimates that industry-wide loan volumes peaked as high as $5 trillion in early-2008; today, they are down to about $2.5 trillion. But much of that run-off occurred in the fourth quarter of 2008 and early part of 2009. Since then, volumes have remained fairly range-bound. That may show that borrowers looked to rapidly deleverage themselves. In fact, the volumes seen today only look small when compared to the levels seen in the time preceding the global financial crisis. Otherwise, today’s levels are correlated with historic norms.
Point of View: If the demand environment today for borrowing securities is fairly steady, what sort of signs are worth watching to detect the next trend in borrower demand?
Jeff Benner: As Chris points out, the borrower demand trends seen recently reflect a slower but steady use of borrowed securities relative to a few years back. But there are probably three key variables we suggest are, in general, worth watching going forward.
First, mergers and acquisition (M&A) activity is one of those bell-weather signals of borrower demand. Just recently, the M&A space is beginning to show some signs of picking up again. The number of deals announced during September and October were about equal to the number announced during the entire previous eight months of 2010. Historically, there is fairly strong correlation between M&A activity and borrower demand, as investors look to capitalize on temporary imbalances and arbitrage opportunities, and are thus willing to pay a premium to gain access to such securities for short-term purposes. If we truly see a material rise in M&A activity, it may follow that borrower demand and loan volumes will grow as we get closer to year end.
Another indicator worth watching is the degree of liquidity gathered by the hedge fund community. Most institutional investors recognize the degree to which hedge funds have been on the receiving end of large cash inflows over the past couple of years. But sometimes it goes unnoticed how much of that cash is still “sitting on the sidelines” — not yet deployed by the hedge fund managers. When we speak to our borrower counterparties, they often mention the high liquidity levels their hedge fund clients maintain. As that cash eventually gets put to work, and as hedge fund managers choose to make some higher-conviction investment choices, we expect to see an uptick in borrower demand and thus possibly an increase in the size of spreads we can extract for clients through lending activities.
Lastly, it is important to note the broader interest rate environment and its impact on borrower demand. Higher interest rates could also spark renewed interest among borrowers of securities. Although the timing and magnitude of future rate increases remains tough to predict, our forecasts suggest interest rates may remain unchanged for at least a good part of 2011. Higher rates, once achieved, simply allow for greater flexibility for the borrowers and thus a potentially more attractive spread opportunity for our clients.
Point of View: Are there any upcoming regulatory changes that may impact the securities lending environment?
Sunil Daswani: There has been a fair amount of focus on the impending regulations across the financial services industry. Sweeping financial regulatory reforms have caused some participants to remain cautious until regulators finalize the rules before proceeding with changes to their lending program. In Europe, challenges continue to be posed on short-selling rules, capital adequacy, creditworthiness, risk mitigation and transparency.
Chris Doell: In the United States, the market’s general focus appears to be on the Dodd-Frank Act, the types of short-selling disclosures that might eventually be required, and how the regulators choose to interpret the “Volcker Rule.” When we interact with our counterparties, they point out that the final rules surrounding disclosure of short-selling activity bears watching, as those requirements may impact some of the activities of hedge funds looking to borrow securities.
Point of View: Has there been a shift in the market from volume lending to value lending?
Sunil Daswani: Yes, there is a measurable shift in the market from volume lending to value lending. There are a few reasons for this. First, the low interest-rate environment — with a sustained flat yield curve — has made lending of certain asset classes less attractive. Then the mismatch between borrowers and lenders in terms of collateral required to be pledged versus collateral actually being pledged has led to a greater focus on the “intrinsic value” stocks being lent only by some beneficial owners.
In some ways, we expect to see a greater reliance on the use of “specials” — meaning those securities that have the greatest intrinsic value to the borrower community, and thus the greatest earnings potential. This is already materializing, as the value of lending “general collateral” positions — meaning securities that are relatively easy for the borrowers to access — has fallen over time.
Point of View: What changes has Northern Trust made to its securities lending program in the past two years?
Jeff Benner: We have made several changes to our securities lending program for the benefit of our clients, in this environment, to deliver a series of tools for clients as well as outreach initiatives. Northern Trust embarked on a series of periodic market update calls designed to offer clients the latest insight on the securities lending and cash reinvestment markets, along with updates on the status of legacy holdings in cash collateral strategies. Additionally, Northern Trust took advantage of its existing Passport® online portal technology to launch the Securities Lending Data Block, which is a powerful online tool for the use of our clients. The result is that today clients tend to be more aware of the intrinsic value of their investment program’s holdings relative to borrower demand, and they use tools, like the ones we offer, to track the results of that demand on their securities lending earnings.
Point of View: What is the outlook for the securities lending market?
Sunil Daswani: Many of our clients have made a concerted effort to re-evaluate the merits of securities lending participation and for the most part, they continue to view securities lending in a positive light. We always encourage clients to keep in mind the long-term outlook and incremental potential return opportunity for securities lending activities. Today’s environment for borrower demand and value generation may feel subdued, but that is coming off of a period when earnings were otherwise boosted by a worldwide economy featuring heavy doses of leverage. Demand from the borrower community has remained steady, giving investors an opportunity to continue profitably lending their securities. As the wave of global de-leveraging and de-risking has taken place, today’s securities lending results are more moderate — yet more in line with historic norms.
Jeff Benner is deputy global head of securities lending for Northern Trust. Prior to his current role, he managed the Northern Trust’s North American securities lending trading desks, which includes the U.S. Treasury, Agency, corporate bond, equity and Canadian trading desks.
Chris Doell, CFA, is head of North American client relations for Northern Trust’s global securities lending practice. Previously, he was a relationship management and institutional sales professional within Northern Trust Asset Management. Before that, he was a custody relationship manager for large corporate clients within Northern Trust’s Corporate & Institutional Services unit.
Sunil Daswani is head of international client relations for all of Northern Trust’s non-U.S. clients involved in securities lending. Previously, he was director and regional manager for securities lending, Asia for Northern Trust, where he evaluated securities lending initiatives for lenders and borrowers.