A New Dawn for Securities Financing Brings Fresh Challenges
By Phil Buck, Managing Director for Europe, GLMX
Patience, diligence, and vigilance have become the critical qualities required to deliver a successful securities lending practice, as the industry evolves to cope with rapidly changing market dynamics and significant increases in regulatory and compliance obligations.
Far from withering in the wake of strains on trust and credibility produced by the financial crisis, securities financing appears to be seeing a new lease of life as fund and portfolio managers strive to “wring every last basis point” out of their securities. In fact, few would disagree that today securities lending has become a critical, integrated part of any serious asset management strategy.
But how, exactly, should lenders, borrowers and intermediaries respond to these new challenges, continue to mitigate risks and still enhance yields to the point where the exercise is worthwhile? Clearly there is a lot to consider.
Regulatory Overload
The 2008 financial crisis and its aftermath had lasting and diverse effects on global markets and economies in a way no other force has in nearly a half century. Great swathes of new regulatory and compliance parameters were passed, oversight increased, business models were turned on their head, and the presence of fintech became virtually ubiquitous.
The increase in regulatory oversight has been the most obvious and burdensome change since 2008, and many of these rules are still in their nascent stages. MiFID II in Europe has led to increased surveillance, while more targeted initiatives like the Securities Financing Transaction Regulation (SFTR), which now looks likely to be implemented in early 2020, are a few of the key reasons market structure will continue to shift.
With the adoption of more robust trading tools, demand for greater efficiency, and the transition from Libor to SOFR, it’s safe to say we should expect additional regulatory reform to hit the securities lending sector in the years ahead.
This trend will continue to tighten its noose around the industry as regulators seek to use greater transparency as one of its key weapons in preventing a repeat of 2008.
Focus on Data
Like many other market activities, data is at the heart of the matter. Though, it appears that market participants and regulators now realize the power and importance of data in securities lending and intend to find and enable technology that maximizes access to analysis of this information.
Data has become a paramount component of securities lending and the wider capital markets. Firms are, therefore, increasingly looking for the most efficient ways to access and procure real-time, clean data, while regulators have taken multiple steps to develop new ways in which to monitor and analyse market data. This was particularly evident when the Office of Financial Research (OFR) within the US Treasury Department proposed a new data collection rule in July that would enhance the FSOC’s ability to detect potential risks across the repo market.
The key to applying that data and delivering successful outcomes in this area is acknowledging that a securities financing program is no longer a commodity. With the onus firmly on the front-office, it is imperative to maintain a balance where revenue should never be traded for risk.
Fintech Injection
By fintech we mean the evolution of specialist technology applications and solutions tailored or designed for the specific needs of the capital markets. These include the ‘electronification’ of manual processes, the aggregation and analysis of assorted data pools and the ability to rationalize, integrate, and simplify previously complex and unwieldy IT systems.
The systemic importance of securities financing markets, especially with the advent of SOFR (and other similar new interest rate benchmarks in various global jurisdictions), requires reliable data sources for which technology offers real solutions. While these markets have been somewhat late adopters in the fintech revolution, technology has nonetheless begun to make its mark in repo and securities financing. This involves the application of real-time data for the analysis and monitoring of collateral, where the acceptance of notoriously volatile equity assets is becoming more widely trusted. As a result, beneficial owners of assets need, more than ever before, access to real-time platforms and sophisticated technology expertise to navigate this new landscape.
Exacerbating this trend is the demand for customized securities financing and revenue generation strategies that are tailored to specific risk profiles and comply with individual risk tolerances. It is no longer one-size fits all.
This trend has also led to a sharp increase in the use of third-party agents to complement traditional custodian-based activity, with up to 40% of large asset managers and nearly 20% of pension funds now opting for this route. This has also helped strengthen indemnification protection in the event of potential counterparty default risk, a consideration that has become even more challenging since the recent decline in the use of cash collateral below that of non-cash equivalent assets.
Nevertheless, these risks can be managed and mitigated with the right level of oversight and informed decision-making, which means access to the right data at the right time is critical.
Change Takes Time
Despite the increased level of electronification across global securities financing markets, a significant amount of trading is still conducted using largely analog processes. The transition gains speed, though, as global interest rates rise, and as regulatory reporting requirements begin to bite. It is something that leaves its actors open to unnecessary risk.
All parties, but particularly beneficial owners, should therefore be adopting more proactive digital and automated technology strategies to ensure actions are supported by the best available data. Some say that to ensure the tightest risk management profile three key lines of defence are required: High Quality Brokers, High Quality Liquid Collateral and Strong Indemnity Assurances from Agents.
We would add that firms must also implement proven (and scalable) technology capabilities to both deliver the data and transparency required by regulators and the information needed by business executives to take the best-informed decisions, now and in the future. These will not only deliver sounder peace of mind, but increase efficiencies and strengthen competitiveness.
Technology is no doubt having a positive and noticeable impact on securities financing, but expect a few more years before there is a widespread adoption of these electronic resources. In the meantime, there are many buy-side traders that will still prefer voice and manual trading, although there is increased realization that the practise is no longer tenable. Change is inevitable and that shift, or transformation, is something that will require adaptability, patience, and vigilance.