SECURITIES LENDING MARKET REPORT€¦ · EY HIGHLIGHTS AND THEMES FROM THE SECOND HALF OF 2017 WERE AS FOLLOWS: - Government bond lending continued to increase over the period, with

SECURITIES LENDINGMARKET REPORT

An ISLA Publication - February 2017 8th edition

Bi-annual Market ReportInsights into the Securities Lending industry

In this 8th edition of the ISLA Market Report, we build upon the themes of

transparency and providing the market with analysis and context.

We encourage feedback and ideas for the next edition.Email: [email protected]

SL Market Report

2018

TABLE OF CONTENTS3 INTRODUCTION

4 EXECUTIVE SUMMARY

5GLOBAL MARKET OVERVIEW & TRENDS

8THOUGHT LEADERSHIP: MAKING A SUCCESS OF SFTR

13 GLOBAL GOVERNMENT BOND MARKETS IN

FOCUS

16 GLOBAL EQUITY MARKETS IN FOCUS

19THE COLLATERAL DYNAMICS

22 THOUGHT LEADERSHIP: ‘ETFS’ - THE NEW FINANCING

PARADIGM

26 DATA METHODOLOGIES

27 ABOUT ISLA

28 DISCLAIMER

PRESS ENQUIRIES

EMAIL: [email protected]

Published on 1 March, 2018

SL Market Report

2018 ALL FIGURES ARE FROM DATA SOURCES BETWEEN JULY - DECEMBER 2017

INTRODUCTION

We are delighted to publish the 8th edition of ISLA’s

Securities Lending Market Report. In January of 2018, we saw the arrival of MiFID II which many expected to bring markets to a halt. In reality and notwithstanding some very real challenges that remain around specific issues such as Legal Entity Identifiers, the market itself continued to function without any noticeable impact on market liquidity or trading volumes.

For our markets, 2018 will be the year of the Securities Financing Transactions Regulation (SFTR) as we work towards implementation in 2019. Set against this backdrop, the first of our thought leadership contributions comes from Regis Trade Repository who consider some of the high-level aspects of SFTR reporting and responses to some of the common questions being asked about the new regime. At the time of writing, we are waiting for the formal adoption process of the Technical Standards that were submitted by ESMA to The Commission in March 2017 to commence. We have previously highlighted that the

The value of on-loan balances globally increased steadily over

the six-month period to just over €1.9 trillion as at the end of 31st December

2017. At the same time, we also observed a gradual uptick in the reported value of global lendable supply of assets, which moved to just over €16 trillion at the year end. Strong market performance over the period contributing to some natural asset appreciation.

Whilst market participants seem to have traded more comfortably

into the year end with a reduction in overall balances, certain data sources

would suggest this continued trend to be more pronounced once again against the receipt of cash collateral.

In the final weeks of the year, we saw considerable balance sheet

and trade management within the government bond space. Cash related trades fell by some 12%

between the 5th and 31st December, whilst non-cash positions saw minimal returns falling by less than 0.5% over the same period.

Non-cash collateral held in tri-party services increased to €1.3

trillion, from €1.2 trillion reported at the end of June 2017. The proportion of equities held in tri-party remained constant at circa 48% of all securities, with much of the incremental growth in tri party balances coming from government bond collateral.

EXECUTIVE SUMMARY

likely costs associated with the implementation of SFTR will be considerable, and significant IT and systems infrastructure budgets have been allocated by the industry to ensure a smooth and successful rollout of this important reporting regime. Through much of the work we have done at ISLA, our industry is both ready and committed to deliver SFTR to the regulatory community and we would hope to see the final Technical Standards published in the very near future. Although there is much to do on this specific piece of regulation, it is something of the beginning of the end as the industry looks towards the future and how our markets will change over the coming months and years.

We have known for some time that securities lending provides a unique window into the functioning of the broader capital markets. It plays a pivotal role around the mobilization of so called High Quality Liquid Assets (HQLA), and how banks behave around compliance with prudential capital hurdles has created a market that did not exist three years ago. We are also beginning to better understand how changing collateral profiles

within our world indicate broader issues such as general collateral availability and liquidity in the short-term money markets.2018 will be a year of both change and anticipation. We are already seeing the impact of the drift towards passive asset management structures with important implications for the lending markets. The use of Exchange Traded Funds (ETFs) as the vehicle of choice by many investors in the passive space raises important questions around transparency and liquidity. Our second thought leadership piece, written by Andrew Jamieson, Global Head of ETF Product at Citigroup Global Markets provides an independent review of the current and future state of ETFs in the context of our markets.

Finally, we remain aware and mindful that Brexit will be with us in some form in just over twelve months. As an association that represents member firms across Europe and beyond, we remain committed to maintaining strong relationships with all our members as well as regulatory and policy maker stakeholders regardless of the final political framework that is agreed in the coming months.

KEY HIGHLIGHTS AND THEMES FROM THE SECOND HALF OF 2017 WERE AS FOLLOWS: -

Government bond lending continued to increase over

the period, with once again all the growth being against non-cash

collateral. Whilst balances against cash began and ended broadly at the same level, one observed considerable volatility over the two reporting dates.

The reported term element (<3 months) of government bond

balances as at the 31st December 2017 compared to six months earlier appeared to be broadly unchanged at 15%.

With government bond balances on an upward

trajectory, equity balances moved to a lesser proportion of the total

on loan at circa 43%.

The disproportionate relationship between supply

and demand for mutual fund assets continued but softened. The data as at the end of December 2017 showed that whilst the pool of assets made available for lending from mutual funds (including UCITS constructs) marginally increased (47%) since June, there was a greater percentage increase in the demand to borrow from these client types (19%).

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SL Market Report 2018 ALL FIGURES ARE FROM DATA SOURCES BETWEEN JULY - DECEMBER 2017

GLOBAL MARKET OVERVIEW & TRENDSAs discussed in the

previous report, global stock markets

flourished in the first half of 2017. This trend continued very much until December, with their best annual performance since the post-crisis recovery. Gains of $9 trillion in value over the year due to a strong worldwide economy (see fig 1).

First, accelerated global growth led primarily by political stability in Europe as well China’s continued prosperity. Further boosts came from corporate tax reforms in the US, giving rise to optimism amongst businesses and therefore increased shareholder returns. Meanwhile, central banks continued use of monetary policy to put more money into the global economy through government bond buy-back

programmes, caused bond yields to fall and equities to become the preferred investment of choice.

Whilst this continued rally into the year-end meant some natural appreciation of assets under management, there were several other direct implications that are important to consider. For banks in general, who are

misleading growth by affecting both the supply value of assets to the market as well as the demand value to borrow them.

As at the end of December 2017, the reported value of global lendable assets increased to just over €16 trillion (see fig 2). In nominal terms, this was an increase of circa 1% since June. Over the same period, the ISLA Global Securities Lending Aggregate1 (see fig 3) increased to just over €1.9 trillion (a circa 3% uptick in the quantity2 of assets borrowed). Compared to the end of December 2016, where we saw a pronounced dislocation in the repo markets sending strong ripples into the securities lending market, nothing so extreme happened as this recent year end. As expected, market participants traded once again more comfortably into the turn,

cash collateral as at the end of December 2017. The level of equities used within the system for collateral purposes has remained broadly at this level since mid-2016. Although we did see higher levels of equity collateral within the system prior to 2016, higher balance sheet and capital costs associated with holding equities suggests that the market has reached something of a natural ceiling, at least in the short term. In 2017, the absence of any notable specials activity or market volatility, particularly in Europe most likely compounded the situation and further restricted the volume of equities in the system. Anecdotal feedback from market participants has also suggested that the growth in government bond collateral, particularly in JGB’s is being driven, in part by a strong US dollar which is leading cash investors into the Asian markets. We explore this

reducing their overall balances. Much of the trimming was open borrows against the receipt of cash collateral. In fact, cash related trades against the loan of government bonds fell by some 12% between the 5th and the 31st December. Non-cash loans in contrast saw minimal returns, with a fall of some 0.5% over the same period (see fig 4). This supports not only the idea of borrowers looking to maintain term Liquidity Coverage Ratio (LCR) trades, but also the lenders inability to spend the cash and therefore close out the position.

Looking closely at the collateral information held in triparty, reported non-cash balances increased by 8% to €1.3 trillion as at the end of 2017. As the chart (see fig 5)highlights, equities continue to play a prominent role in this market and once again represented 48% of all non-

Fig 2: Global Securities *Source: IHS Markit

Fig 3: ISLA Global Securities Lending Aggregate *Source: ISLA

Fig 4: All Securities Collateral breakdown*Source: IHS Markit

Fig 5: Tri-party Non-cash Collateral by Asset Class Source BNY Mellon, Deutsche Bourse, Euroclear, JP Morgan

Fig 1: Market Summary: Dow Jones Industrial Average *Source: NDEXDJX: .DJI

1 ISLA Global Securities Lending Aggregate is compiled using data from DataLend, IHS Markit, and FIS Global. Please also see Data

Methodologies section. 2 Quantity is an alternative measure of securities lending activity that filters out changes in the valuation of the underlying securities.

closely monitoring and managing their balance sheets, bullish markets can have an unintended impact of inflating usage and therefore cost. These issues are further compounded for Global Systemically Important Banks (G-SIB’s) who must adhere to stricter and higher regulatory hurdles. For securities lending balances specifically, positive price movements can indicate

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SL Market Report 2018 THOUGHT LEADERSHIP FEATUREphenomenon in more detail in the government bond and collateral sections.

The demand to borrow government bonds showed no real signs of slowing down in the second half of last year, representing some 47% of the global on-loan balance at the end of December. At the same time, the supply of government bonds globally remained somewhat unchanged. Looking at the major markets, some interesting nuances supporting or rather contradicting these global trends. In the US, the

supply and demand for US government bonds moved steadily in an upward trajectory with no significant change in utilisation over the period. In contrast however, and whilst the demand for European government bonds remained relatively strong, we did see supply steadily decrease. This could be the continued manifestation of the buy-back programmes taking further bond liquidity out the market.

The growing term element associated with the demand for HQLA government bonds has been a trend since the inception of prudential capital

regimes. In contrast to prior reporting dates however, we saw no material change in this type of business at the end of December. Whilst this in isolation may not highlight anything significant, anecdotal evidence combined with other supporting statistics does suggest a potential shift in borrower behaviour.

One such statistic might be the marginal increase in banks borrowing from mutual funds. We have talked extensively about the disproportionate relationship between the supply of assets from mutual

funds (see fig 7) and the demand to borrow from them. At the end of December 2017, pension and mutual funds combined still represented 67% of the entire pool of assets made available for lending (see fig 6). Whilst 47% of that total was attributed to mutual funds (including UCITS) however, we saw a marked increase to borrow from these client types

(up by 4% to 19%).With no material movement on collateral guidelines or rules that govern mutual funds around collateral acceptance and term of trade, what might explain this slight shift in sentiment? One possible reason could be that whilst these trades are not optimal to the borrower, the asset mix on offer may deem them

more attractive. Furthermore, whilst these trades might be less favourable from a balance sheet perspective, notably eligibility for LCR, the high Risk Weighted Assets (RWA) costs associated with other client types such as Sovereign Wealth Funds may in fact make the shorter tenure requirement, amongst other constraints more palatable.

THOUGHT LEADERSHIP MAKING A SUCCESS OF SFTRBy Jo Hide, Trade Repository SME at REGIS-TR

TR, on time and complete. For SFTR, data can only be submitted to the TRs in ISO 20022 XML format – no csv or Excel files will be accepted. On the one hand, the ISO 20022 format is more complicated to create than a plain old spreadsheet. On the other hand, the great benefit of ISO 20022 is that so much of the data validation is contained within the format definition – the successful creation of a file already guarantees the quality of a great deal of the data you’re submitting, before it even reaches the TR.

Once your data has been received, the TRs will re-confirm the validity of the data in the file, and carry out other checks like:

ENSURING the UTI has not already been used for another trade

VALIDATING certain data against reference data lists (for example, LEIs, currency codes, venue codes)

PREVENTING illogical workflows (for example, preventing a modification from

being reported against a trade which has already matured)

Records which pass all the checks will be submitted to the TR. For those which don’t, you’ll need to correct the errors and re-submit the affected records within the reporting deadline.

RECONCILIATIONSFTR, like EMIR, is a dual-sided reporting regime. This means that, as with double-entry book-keeping, trades must be reported from both counterparties’ perspectives, and the details reported must match one another, or be corrected until they do. The reconciliation of reported trades is carried out by the TRs on a daily basis and will follow the technical standards laid down by ESMA. For SFTR, we expect those to look a lot like the process which TRs follow for EMIR:

1The TR checks each trade it holds to see if that trade should be submitted

for reconciliation – trades reported against individuals and non-EEA counterparties, neither of which have a reporting obligation under the regulation, will be excluded.

Fig 7: Global On-Loan split by Fund TypeSource: IHS Markit

3 Pending authorisation from ESMA once the service extension application process opens later in 2018

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Fig 6: Global Lendable Supply split by Fund TypeSource: IHS Markit

MAKING A SUCCESS OF SFTRThis time next year, we expect firms will be progressing well through their SFTR transaction reporting projects and gearing up to start sending the first records to Trade Repositories (TRs) across Europe. As with OTC derivatives before, this transaction reporting is a new endeavour in the Securities Financing and Repo world, with new terminology, new workflows and, inevitably, new concerns arising as the reporting start date approaches. As one of the largest TRs under EMIR, and a future TR for SFTR3 , we uncover some of the high-level aspects of SFTR reporting, and answer some of the questions which we’re being asked about the new regime. Most importantly, we look at how you can make a success of SFTR and avoid that knock on the door from your regulator.

DATA SUBMISSION AND VALIDATIONThe first step towards successful reporting is to get your trading data into your

SL Market Report 20182 For each trade which

remains in-scope after step 1, the TR tries to

find a pairing record internally within their own database. In order to pair, the UTIs must match, and the LEIs of the two counterparties must be the mirror image of one another. For this stage to work, it’s crucial that the correct UTIs and LEIs are used on the trade to find the other side of it.

3 If the TR can’t find the pair to the trade internally, it will include

the UTI and both counterparty LEIs in a list which it will share with all the other TRs. This is called the requested list.

4 Once per day, all the TRs share their requested list with all the other TRs.

Each TR then llooks in its database to try and find the pair for the other TRs’ records.

5 When it finds a trade that another TR is looking for, it includes the trade

details in a file created only for the TR which was searching for that trade. This is called the trade data details file.

6 When all the trades have been searched for, the trade data details files are

sent to the other TRs, and the TR runs the reconciliation.

7 Once run, the TR will show or report to the reporting firm the

results of the reconciliation, highlighting which fields do

SOME fields are considered ‘must match’ fields, others are ‘should match’, some are ‘won’t match’ – and the processing reflects that logic. OUR RECOMMENDATIONSGiven what we know of reporting under EMIR, of what works not just in terms of carrying out the reporting in a timely and accurate manner, but also that all-important Inter-TR reconciliation process, we note that the following strategies have been the most effective in getting high rates of reconciliation success:

DELEGATING REPORTING TO YOUR COUNTERPARTY

not match and need to be amended.

Whenever an amendment is made to a trade, the TR will automatically re-submit that trade to the Inter-TR rec process again, so that the modified details are re-reconciled.

And any trades which don’t find a pair are included in the requested list again the following day. THE CONCERNS As a TR, we hear two main refrains when we speak to the SFT industry about SFTR reporting, and they both relate to the Inter-TR reconciliation:

1. If we use a different Trade Repository to our counterparty, we’ll never

get anything to match in the Inter-TR reconciliation

2 There’s no way we’re going to be able to match every field exactly with

our counterparty THE REALITY On the first point, and as described above, the first step to successful reconciliation is ensuring that you report with the same UTI and LEIs as your counterparty - that requirement is the same whether you report to the same TR as your counterparty or a different one. It’s worth pointing out that the Inter-TR rec process (where the TR looks for a pair to your trade in another TR) follows exactly

the same logic as the ‘Intra-TR rec’ (where the TR searches its own database for the pair). The software code which runs is completely agnostic as to the source of the other side of the trade, so it actually makes no difference whether you both report to the same TR or not. On that basis, there’s no benefit to ‘letting the reconciliation tail wag the reporting dog’ – you’re free to choose the reporting service and TR expertise that best support you and your business needs.

On the second point, and contrary to popular belief, the Inter-TR reconciliation does not expect a perfect match on every field. TRs jointly apply various common-sense methods to reduce extraneous reconciliation failures under EMIR reporting: FREE text fields are excluded from reconciliation – for example the field where you provide a long description for interest rate swap trades

SOME numeric fields have tolerances or rounding applied – some trading systems hold numeric values to differing numbers of decimal places, or use different exchange rates to convert between currencies

SOME date and time fields have tolerances applied – where trades have been confirmed non-electronically, TRs only check that the dates match between the two sides of the trades, not the times

In contrast to the derivatives world, where counterparties to trades are already in possession of virtually all data which needs to be reported under EMIR, in the Securities Financing world the data required to be reported by both firms is asynchronously distributed, with Clearers, Lenders and Brokers holding the lion’s share of the information. On that basis, and in order to simplify workflows between counterparties, we recommend considering delegating your reporting to your Clearer, Lender or Broker if they are offering that service. Bear in mind that delegated reporting in no way gets you ‘off the hook’ in ensuring

the timeliness, quality and accuracy of the reporting - that will still remain your responsibility and you will need to demonstrate that you have workflows and processes in place to check what has been reported on your behalf, and have any errors corrected. USING A THIRD PARTY Similar to the above, if you’re using a platform to trade or confirm your trading, check whether your provider will offer an SFTR reporting service and how it will function. Some third parties offer a full end-to-end service, whereas others will prepare the data records for you so that you can send them to your TR yourself.

THOUGHT LEADERSHIP FEATURE THOUGHT LEADERSHIP FEATURE

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SL Market Report 2018

SHARING THE UTI ITSELF, NOT THE UTI GENERATION ALGORITHMUTIs are a novel concept in each reporting regime they are extended to. The concerns in the Securities Financing world reflect those we saw particularly in OTC derivative trading for EMIR - who will generate the UTI? How will they create it? How will they distribute it? How do I know I’ve used the same UTI as my counterparty? How can I be sure the UTI is generated in time for me to complete my reporting? With the assistance of some of the trade associations, some common ground was established under EMIR in answering these questions.

As trade principals, many CCPs took responsibility for generating the UTI for themselves and their counterparty, reflecting the workflow which had been adopted for Dodd Frank reporting in the US. Similarly, many Clearing Members generated for themselves and their client. The way those UTIs were shared followed one of two methods: Most CCPs publish the algorithm which they use to create the UTI, so that the CM can create that same UTI in its systems. This saves the CCP from having to distribute the UTI to the CM in a manner which is timely enough that

It needs to be actively managed and remediated to keep in compliance with the regulation – and this is where your reporting service provider or Trade Repository can help.

Choosing whether to report directly to a TR or via a third party or counterparty may well boil down to this: if your own systems or data warehouse can generate all the data points required within the reporting deadline, a direct relationship with a TR, offering workflow simplicity and consolidated data views and management, may suit you best. If you’ll need to look outside of your organisation for help in generating all the required data, then reporting via a third party or counterparty may be the most efficient approach.

You’ll need to receive information from your TR or reporting service provider about your reported data so that you can identify issues and carry out pro-active, focused investigations into any problem areas. Ideally, you’ll be looking for information about:

the CM can use it in its own transaction reports. Whilst straightforward enough in theory, the implementation of this process has not been entirely successful. For one thing, it means that CMs have to implement multiple UTI generation algorithms, since each CCP has created a different UTI-generation algorithm. Secondly, what looks good as an explanation on paper, is not necessarily implemented directly as anticipated – we’ve seen numerous cases where two parties, using the same algorithm, end up with differing UTIs.

A few CCPs, however, send the UTI they have generated to their clearing member with the clearing confirmation. The Clearing Member consumes the UTI which the CCP sends them. This requires a new workflow to be put in place but guarantees that the same UTI will be used by both parties when they report the trade – going a long way to ensuring trade pairing takes place successfully.

WORKING ACTIVELY TO RESOLVE ISSUESOur most successful and compliant firms understand that, when it comes to transaction reporting, you never get the day off! They dedicate staff to working actively to resolve issues in their reporting and look for constant improvements. As we’ve seen with some of the

areas we’ve focused on with our clients, the hard work pays off and, given the amount of data to be reported, issues which are left unchecked only compound and create knock-on effects.

*STOP PRESS*On 23rd October, the FCA issued the first ever fine across the EU for mis-reporting under the EMIR regime, with failures resulting in a cool £34.5m write-down for the firm involved. Full details can be found on the FCA website www.fca.org.uk by searching for ‘EMIR fine‘ The report makes for sobering reading, and acts as a stern warning for reporting firms regarding the importance of:

SUFFICIENT resourcing of reporting teams

ONGOING and pro-active independent testing

ADDRESSING identified risks and audit findings

SENIOR Management oversight and accountability for the reporting workstream

WHAT TO LOOK FOR IN A REPORTING SERVICE PROVIDER OR TRADE REPOSITORYHowever you conduct your reporting, whether through a third party or counterparty, or by directly submitting your reports to your TR, it’s clear that transaction reporting is not a ‘fire and forget’ endeavour.

REPORT submission volumes

RESOLVING late submission issues

RESOLVING general TR validation failures – you’ll need to correct the errors and re-submit the affected records within the reporting deadline

RESOLVING LEI validation failures – virtually every party to the trade require an LEI, which go through cycles of expiry and renewal, as well as periodic changes

RESOLVING TR pairing failures with counterparties

RESOLVING TR reconciliation breaks with counterparties

INFORMATION about the reconciliation rates versus each of your counterparties – this will let you see whether there are particular firms where you’re not submitting the same data

INFORMATION about the individual fields which are causing the reconciliation failures – this will uncover whether you and your counterparties are consistently submitting differing values in some fields

PERIODIC reporting performance reviews – MIS for audit and compliance purposesAnd you’ll also need to select a provider or TR which runs a Helpdesk dedicated to their regulatory reporting service, who understands the specifics of the Securities Financing business and the SFTR regulation, and who can support you in resolving any issues in a manner timely enough to keep you in compliance.

IN CONCLUSIONPragmatically speaking, perfection is not expected on day one – however, regulators have promised that ‘non-compliance will always be more expensive than compliance’ and arguably the total cost of compliance is more than just the monthly fee you pay to your service provider or TR. Due diligence in evaluating the various service offerings which are starting to surface will reap dividends in the long run, demonstrating to senior management, regulators and clients alike that the necessary systems and controls are in place – and avoiding the financial and reputational damage which accompanies a breach.

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THOUGHT LEADERSHIP FEATURE


As at 31st December 2017, €897bn of government bonds were on loan.

This represented a 13% increase in government bond lending during 2017 (see fig 8) with government bonds now representing 47% of all securities on-loan as at the end of 2017.

GLOBAL GOVERNMENT BOND MARKETS IN FOCUS

Available securities or lendable remained almost unchanged during the six-month period to 31st December 2017 at €2.2 trillion. As the on-loan balance increased during the period however, the proportion of securities on-loan increased from 37% to 40%. Whilst this measure still indicates that there are many securities that could be lent by investors, it should be noted that as utilization levels rise there could be implications for market liquidity, particularly in smaller issues. Also, as demand increases around key reporting dates, we would expect to see an increase in lending fees as investors demand a higher premium to lend HQLA over the year end.

Of the €897 billion of government bonds on-loan, €699 billion or 78% of all loans were against non-cash collateral underpinning the importance that the securities

lending market plays in the mobilization of HQLA.

Here, the most significant ratio has been the LCR where borrowers (banks and other principal borrowers) may include any borrowed HQLA assets in their LCR calculations provided the trades are for three months or longer. Aligned to this point, the chart (see fig 9) highlights how the market successfully traded into the year end without the disruption seen in 2016 with a clear preference to maintain what are most likely to be LCR driven non-cash trades.

In the final weeks of the year, we did observe some balance sheet reduction particularly in respect of government bond loans against cash collateral. Although we discuss the drivers behind cash collateral in more detail in a subsequent section, it is important to recognize that cash collateral can fall out of favour or prompt recalls if reinvestment opportunities are either scarce or yields offer insufficient returns to cover any rebates paid to the borrowers. Whilst these factors are ever present, they

may become compounded over key reporting dates as general market liquidity tends to fall.

In Europe, some of the trends seen at the global level were in fact seen in starker relief within the government bond lending markets. On-loan balances of European government bonds increased by nearly 3% in the final two weeks of the year (see fig 10). This market, which is already dominated by non-cash collateral saw all the growth in lending against non-cash trades (up to 94%).

In previous reports we have also considered two further factors that drive this part of the market; the development of a term lending market in HQLA as part of LCR trading strategies, and the concentration of supply in terms of the role of Sovereign Wealth Funds (SWF) in providing liquidity into this sector. Although these factors are still very much part of the landscape associated with the lending of government bonds, we have observed some subtle changes in the past six months that suggest that the market and borrowers are becoming better adept and working within the new prudential frameworks.

In the past two years, we have seen the development of a term lending market for the loan of government bonds that is almost exclusively driven by the rolling impact of the LCR. Collecting high quality data relating to term transactions is problematic, so whilst reported levels of term transactions can be as high as 24%, anecdotical evidence suggests this could in fact be as high as 50% of all

loans of government bonds. Since January 2017 reported levels of term transactions have softened for the second successive period to circa 15% for government bonds (see fig 11). Factors driving this change could be varied but are likely to include banks reaching natural capacity in this area, the general strengthening of balance sheets negating the need for further LCR specific

trades and finally a change in borrower’s preferences to transact with certain counterparty types.Historically, much of the growth in term HQLA lending has been associated with SWF’s who were often able to contemplate term transactions. In contrast, their peers such as UCITS funds have been progressively excluded from this market due to regulatory

Fig 11. Global Government Bonds On-loan by Term of LoanSource: DataLend

Fig 8: Global Government BondsSource: IHS Markit

Fig 9:Global Government Bonds Collateral BreakdownSource: IHS Markit

Fig 10: European Government BondsSource: IHS Markit

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constraints. This has led to SWFs capturing up to 33% of this market set against a backdrop of only representing circa 6% of global supply of all securities. In this latest report, we have seen something of a lessening of this dynamic. Again, this may reflect several complementary factors, but borrowers appear As at 31st December

2017, there were circa €833 billion of equity

securities on-loan drawn from a reportable lendable pool of €11 trillion. As we have seen in prior reporting periods, on-loan balances opened and closed the six-month reporting period virtually unchanged, with US equities again representing the largest proportion of this market at 54% of all equities on-loan.At €11trillion, reportable lendable was up by 7% (see fig 12). As discussed in previous sections of this report however, we remain very mindful that the valuations associated with both lending inventory and on-loan balances are subject to any changes in the price of the underlying securities involved. Simple perusal of any main equity index in the second half of 2017 highlights considerable asset appreciation during the period with many stock markets closing 2017 at record highs.

Initial review of global quantity data for the second half of 2017 suggests that both on-loan balances and available securities fell marginally into the year-end compared to the positive comparisons when value is used. Although both

to be switching some business away from SWF’s where residual counterparty risk tends to attract high RWA charges. At the same time, they are looking to other counterparty types tactically where term transactions may not be as crucial as accessing the relevant security even on a short-term basis. This

dynamic may change again as other ways of business such as pledge collateral and central clearing gain momentum. We hope to review this dynamic in subsequent reports.

GLOBAL EQUITY MARKETSIN FOCUS

the fall in lendable and on-loan balances when quantity is used are marginal at less than 3% in both cases, quantity clearly provides an invaluable additional data point.

As we look more deeply at the second half of the year, many interesting trends warrant further consideration. First, as previously noted, equity securities lending on-loan balances opened and closed the reporting period at very similar levels. We have seen this in prior reporting periods and notwithstanding the demand to borrow securities, there would appear to be something of a capital, balance sheet or Risk Weighted Asset ceiling to support this business globally. This is perhaps not surprising as banks and other institutions must allocate scarce capital and balance sheet resources across multiple business lines. This does however raise some interesting questions around market capacity and how market participants may drift towards other trading conduits such as central clearing or peer to peer platforms, which may be regarded as less capital intensive.

In the period prior to the year end and unlike 2016,

there was a clear and orderly reduction in on-loan balances. We have already considered how compliance with critical reporting hurdles associated with scarce capital and balance sheet resources will naturally constrain on-loan balances, but other factors around broader market liquidity also come into play. This can be seen in how cash collateralised trades appear to be reduced first and in preference to non- cash collateralised trades (see fig 13)

As discussed elsewhere in this report, securities lending and in particular the reinvestment of cash collateral can be very sensitive to both short term money market yields and general market liquidity. In the case of the former, if short term yields are insufficient to cover the cost of the interest paid to the borrower on its cash collateral and provide sufficient additional yield to compensate the lender for the perceived risks associated with lending the underlying security, lenders may prefer to demand non-cash collateral. Similarly, lenders may also be faced with few options to reinvest cash collateral over critical reporting dates as money funds and other short-term investment conduits become constrained.

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This often leaves the lender with no option but to recall those loans even though the borrower would keep the position open over the year end. Fig 13 highlights how these factors contributed to a 7% fall in loans of equities against cash collateral in the final two weeks of 2017, whilst loans of equities against non-cash collateral remained almost unchanged.In Europe (see fig 14), the equity securities lending market mirrored the broad themes seen at the global level with on-loan balances opening and closing the period at similar levels and with lendable supply also reflecting the asset appreciation factors discussed earlier.

At a trading level, we did observe some volatility or increased demand from borrowers during the period, however this appears to have been confined to North

American markets. Having said that, even here we did not see the experience of 2016 with the emergence of so called ‘super specials’ such as Tesla. As we look towards 2018 and beyond, we would expect to see both greater demand and underlying volatility as the European economy recovers still further prompting greater corporate M&A activity as well as driving demand for short side players to re-enter this side of the market.

Fig 12: Global EquitiesSource:IHS Markit

Fig 13: Global Equities Collateral BreakdownSource:IHS Markit

Fig 14: European EquitiesSource:IHS Markit

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Historically, the role of collateral in securities lending has

been to provide the lender with an asset (cash or other securities) that would act as a buffer against any losses associated with the inability of the borrower to redeliver equivalent lent securities. This simple risk mitigant function is still paramount today, but due to increasing complexities associated with various prudential capital regimes and the interaction with other short term markets the role and importance of collateral is now often a key driver or factor in any given trade. For example, a borrower may prefer to source securities from a lender who is either prepared to look at a broader range of collateral or consider term transactions.

At a global level, the securities lending market is dominated by non-cash collateral which represented 66% of all open loans at the end of December 2017. We have noticed a drift towards the use of non-cash collateral since we started tracking this metric in 2016 and in certain asset classes such as government bonds cash collateral is seldom


THE COLLATERAL DYNAMICS

used today. Fig 15 highlights the dominance of non-cash collateral but also looks at how the market appears to have opted to take off cash collateralised trades in the run up to the year-end.

In the final two weeks of the year, we saw a 9% fall in cash collateralised business, whilst the fall in non-cash trades was marginal at less than 1%. When thinking about this dynamic, a number of factors come in to play. First and not unexpectantly market participants will tend to reduce trading activity over key reporting checkpoints to boost regulatory numbers. However, if this were just the case, we would expect to see a similar pattern across

all trades and not just cash collateralised ones. Other factors that drive the cash collateral market revolve around general liquidity in the short-term money markets. As lenders who are the recipients of cash collateral see limited opportunities to reinvest cash collateral at a rate that they deem to be sufficient, they may opt to simply recall the security and return the cash to the borrower. This factor is compounded over key reporting dates as money funds, who are often the beneficiaries of much securities cash collateral, effectively turn away liquidity over the year end as they themselves have limited investment opportunities.

We have already highlighted the reported growth in non-cash collateral held in triparty in Europe, where we saw an increase in assets held by the four main providers. We have also discussed the important role that equities play in the collateral landscape today and this is, in part driven by the markets desire to mobilise HQLA assets typically against equity collateral.The level of equities used within the system for collateral purposes has remained broadly at this level since mid-2016 and suggests that the market and in particular lenders have reached something of a resistance level to further use equities as collateral. Part of this may be regulatory driven with many funds and other institutions unable to consider equities as collateral. Whilst we would expect this to change over time, progress is likely to be slow.Whilst equities as a proportion

of the overall collateral pool has remained stable, we have observed incremental use of government bond collateral (a rise from 39% of all non-cash collateral in June 2017 to 41% as at the end of 2017 (see fig 16)). The reasons behind this apparent growth are likely to be varied and driven by other external factors.

To get closer to these, we have for the first time been able to gain better transparency into the nature of the government bond collateral being used by market participants within securities lending. Fig 17 details the regional domicile of the underlying issuers of the government bond collateral being delivered by borrowers.

As we would expect, issues from European government institutions dominate the collateral pool representing over half of all government

Fig 15: All Securities Collateral breakdownSource:IHS Markit

Fig 16: Tri-party Non-cash Collateral by Asset Class Source BNY Mellon, Deutsche Bourse, Euroclear, JP Morgan

bonds being used as collateral. Interestingly, the second largest share by domicile comes from Asia (33%) where JGB’s dominate with North America at 10%. The relative levels of both JGB’s and US Treasuries are somewhat out of line with both their underlying bond markets and their participation in lending programmes. For example, US Treasuries represent 62% of all government bonds on-loan yet they do not figure prominently in the tri party collateral world.

First, it would appear that borrowers may simply be using borrowed US Treasuries as part of their inventory and when combined with term transactions, they are using them as part of their LCR compliance regime. Secondly, the relative strength of the US dollar foreign exchange rate in the past twelve months has led to certain anomalies in the

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Exchange Traded Funds (ETFs) have long been viewed as

peripheral within the confines of the European Securities Financing world, whether that is lending to harness increased yield, borrowing to facilitate short coverage or financing & collateral pledging to fulfil other obligations. There are however now clear signs this is changing and changing rapidly, such that they may in time, play a much more mainstream role like they do in the US.

LENDINGThere is little to debate when it comes to the merits of ETFs within the broader

THOUGHT LEADERSHIP ‘ETFS’ - THE NEW FINANCING PARADIGM’ By Andrew J. Jamieson, Global Head of ETF Product at Citigroup Global Markets


investment landscape. They are cost effective, trailblazers in transparency and lead the way in the democratization of investing. This affords access to markets and instruments typically out of reach for many investors, both large and small by utilizing the benefits of its unique wrapper. Over the last 2 years alone, we have witnessed a near $1 trillion switch from traditional actively manged mutual funds into passive ETFs and as a consequence global AuM has risen sharply to $5 trillion globally. What is often not appreciated is that ETFs are largely an institutional tool outside of North America

and make up considerably more than half of the global ETF AuM. Consequently the traditional participants in the Securities Finance marketplace (i.e. Beneficial Owners) are also actively involved in the growth of ETF adoption and use. Despite considerable early hurdles, such as nomenclature challenges, multiple sedols (due to cross-listings), classification confusion and perception inaccuracies (“nobody owns them” / nobody wants them” / “they are a retail only product” being some of the most common) availability and on-loan balances within the Securities Lending marketplace have risen steadily over the last few years and continue to do so. In the table left, courtesy of Markit, in the last two years (since January 2016) we have witnessed an increase in visible availability of nearly 90% from just under $30 billion to over $55 billion in Europe alone. Similarly, on loan balances, whilst more volatile, have increased

SL Market Report

2018Fig 17: Government Bond Collateral by Domicile of issuer

Source BNY Mellon, Deutsche Bourse, Euroclear, JP Morgan

EMEA ETF Availability and on loan balances

term money markets (switching from US dollars to other currencies including Yen, investors are able to monetise these anomalies). This market dynamic is potentially being played out in the securities lending markets whereby investors who have moved into Yen and are looking for a short term ‘safe haven’ for their cash investment, are opting to purchase JGB’s in either outright or repo markets. As investors/banks find themselves long these high-quality government bond assets, it is inevitable that we are seeing them appear in the broader securities lending non-cash collateral pools.

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from $3 billion to over $5 billion (an increase of 75%) illustrating the increasing adoption of ETFs as a macro hedging tool. As Fixed Income investors, who have long been accustomed to going short as well as long similar instruments, hedge funds and even more traditional asset managers are using ETFs to tactically exploit segments of the market; then the demand to borrow ETFs will surely grow. Additionally, an increasing awareness of the need to settle ETFs on a timely basis, a particularly sensitive issue for overseas investors in Latin America & Asia, is driving increased market-


maker appetite. Furthermore, the growth in secondary activity such as a nascent options market on ETFs in Europe will further fuel demand in the long term. We have already witnessed this in the US where an active options market on High Yield Fixed Income ETFs in particular, has driven demand to near 100% utilisation and significant fee generation in certain names. In fact there are now over 150 ETFs globally where the annualised average lending revenue outweighs the cost of the ETF management fee.

COLLATERAL Notwithstanding increased lending demand, this is not the only driver of change. The desire

to pledge ETFs as collateral particularly in relation to the evolving regulatory environment is propelling ETFs to ever greater acceptance as a collateral instrument in their own right. MiFID II has led to much greater transparency on true ETF trading volumes in Europe, where OTC activity has traditionally accounted for upwards of 70% of daily turnover that (until now) has largely been invisible. This greater transparency coupled with ever more requirements to pledge collateral (for example – EMIR pressures) and the inherent in-built diversification makes ETFs an ideal instrument regardless of some of the current

lenders are still unable to unlock their full inventory as they are unable to identify them in their Custody system, overcome the multiple sedol or ISIN identifier challenges or wrongly believe there is no appetite to borrow and invariably therefore do not prioritise adding them to availability feeds. Unsurprisingly Prime Brokers have historically been uncomfortable indicating stable supply to Hedge Fund customers that in turn ultimately depresses and stifles potential demand and simultaneously creates a vicious circle of inactivity. Similarly using only on-exchange volume data, which vastly under emphasises the true secondary market liquidity, let alone the implied liquidity the underlying index represents, results in a skewed impression.


hurdles in classification. The development of industry standard metrics (Markit ETF Lists) has simplified understanding and removed the traditional heavy lifting required in understanding the myriad of ETFs in existence and consequently the challenge of knowing which ones would be suitable to accept. By eliminating individual and bi-lateral negotiations as to which ETFs to accept, by replacing it with an automated process of pre-approved criteria supported by the tri-party platforms, greatly simplifies the process and increases speed to market. At the time of writing there are probably as many as twenty firms who now have adopted the Markit Lists as a framework for taking ETFs as collateral and Citi is only the latest of a number of leading custodian lenders to announce they are doing so.

As the chart above right courtesy of BNY Mellon illustrates, the volumes of ETFs within their European tri-party platform is now substantial and growing. Over the same two year period from January 2016, ETF collateral balances have risen by almost 200%, with significant growth in the last 3 months on an ever increasing trajectory. MORE TO DOThere is of course still much more to do. In relation to a global ETF AuM of $5 trillion, these numbers on-loan or pledged as collateral are still modest at best. Many major

As an example, on one observed day towards the end of January 2018, a leading UCITS FTSE100 ETF recorded 1.6 million units traded on the London Stock Exchange (as reported on Bloomberg), but a further 12.2 million were reported under MiFID II (also on Bloomberg but on a different page), giving a true picture of the 13.8 million shares that traded. Additionally by utilising Bloomberg’s “implied liquidity” function – a measure of how many theoretical ETF units could trade in the underlying securities without causing market impact - the number jumps to an impressive 121.8 million shares, a more representative figure for an open-ended investment vehicle. Similarly, failing to “look-though” to the underlying security penalises ETFs in particular, as by their


BNY Mellon International Tri-Party ETF Balances

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very nature they cannot be “blue chip index constituents” even though that is often exactly what they replicate in their entirety and are undoubtedly a better solution in a collateral context due to their in-built diversification. This is nowhere more relevant than in the scenario of US Treasury ETFs that often fall foul of punitive Capital Treatment being classified as an illiquid equity, rather than triple-A rated government


paper, merely within an ETF wrapper.

Notwithstanding these challenges and issues, demand and interest drives change and therefore regardless of which side of the lending, borrowing or collateral giving & receiving conundrum your firm sits on, being vocal about your interest is key to resolving the current situation and bringing ETFs fully into the mainstream within the

securities finance context. The opportunities for ETFs outside North America in all scenarios are growing swiftly and in line with the wrapper itself. Therefore the revenues derived from Securities Finance related activity are also increasing accordingly, so not being involved risks missing out on a significant part of that important new revenue stream.


ABOUT ISLAThe International Securities Lending Association (ISLA) is a trade association established in 1989 to represent the common interests of participants in the securities lending industry.

ISLA’S AIMS:

1 To provide guidance to the securities lending industry

and to be its leading voice within the EMEA regions.

2 To create a professional and interactive environment

for its membership, and promote the industry’s global development.

3 To ensure sound industry practices, improve

industry transparency and education, highlight industry developments and to liaise with the wider financial community, institutional investors, the media, other trade associations, regulators, governments and policymakers.

4 To work with regulators to provide a safe and efficient

framework for securities lending and enhance the public profile of the industry.

5 To sponsor the Global Master Securities Lending

Agreement (GMSLA) as the market standard legal agreement, both title transfer and pledge versions as well as the ISLA netting opinions.

DATA METHODOLOGIES & SOURCES USED

This ISLA Securities Lending Market Report has been compiled using

a range of data contributors together with specific information provided directly by our members through surveys and questionnaires. We would like at this point to thank all of the various contributors for their efforts in assisting ISLA in the production of this report.

Loan information that includes details of securities on-loan across different asset and client types has been provided by three institutions that provide commercial data and benchmarking services for the securities financing industry. DataLend, IHS Markit and FIS Global all collect data from industry participants on a high frequency basis and provide a range of securities lending benchmarking analytics that allow firms and their clients to better understand and assess the relative performance of any given lending programme.

Whilst each of these data providers covers broadly the

same market we havechosen to use data from each to reflect the fact that each has a slightly different business model and client mix and therefore provide differentperspectives across certain asset classes or regions. By adopting this approach wehave been able to develop and publish the ISLA Global Securities LendingAggregate. This aggregate, that will be used to develop consistent trendindicators over time, has been compiled by combining information from each of the commercial data providers. The ISLA Global aggregate was compiled to provide the most representative global estimation of the size and scope of the securities lending markets. In compiling the aggregate we took the largest securities lending on loan balance provided by the three commercial data providers as a starting point for the calculation. This global onloan balance was then adjusted to reflect incremental data from the other commercial data providers where their

reported on-loan balances across different asset classes or regions created a more representative overall global number.

All regional and geographic analysis reflects the location of the issuer of thesecurities (as opposed to the location of the lender or borrower) asthis is the basis on which the providers collect and analyse their data.

Data from the principal tri-party service providers active in Europe today is alsoincorporated within the report as part of our analysis of collateral.

ABOUT ISLAISLA works closely with regulators across Europe and our activities embrace markets and prudential regulatory regimes as well as investor protection. In the United Kingdom, the association has representation on the Securities Lending Committee, a committee of market practitioners chaired by the Bank of England.

ISLA has contributed to a number of major market initiatives, including the development of the UK Money Markets Code and the industry-standard lending agreement, the Global Master Securities Lending Agreement (GMSLA). ISLA has over 140 members comprising of insurance companies, pension funds, asset managers, banks, securities dealers and service providers. While ISLA is based in London, it represents members predominately across the UK and Europe, and across the globe.

In 2016, ISLA appointed Andrew Dyson as its Chief Executive and has an elected Board of fifteen industry professionals, representing firms from all parts of the industry globally.

Further details may be found at: http://www.isla.co.uk/


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DISCLAIMER

While we have made every attempt to ensure that the information contained in this Report has been obtained from reliable sources, International Securities Lending Association (ISLA) is not responsible for any errors or omissions, or for the results obtained from

the use of this information. All information in this Report is provided “as is”, with no guarantee of completeness, accuracy, timeliness or of the results obtained from the use of this information, and without warranty of any kind, express or implied, including, but not limited to warranties of performance, merchantability and fitness for a particular purpose. Nothing herein shall to any extent substitute for the independent investigations and the sound technical and business judgment of the reader. In no event will ISLA, or its Board Members, employees or agents, be liable to you or anyone else for any decision made or action taken in reliance on the information in this Report or for any consequential, special or similar damages, even if advised of the possibility of such damages.


Documents

SECURITIES LENDING MARKET REPORT€¦ · EY HIGHLIGHTS AND THEMES FROM THE SECOND HALF OF 2017 WERE AS FOLLOWS: - Government bond lending continued to increase over the period, with