By Jennifer Hanes, Division Executive, Securities Finance & Processing - FIS
Much has been made of the raft of pressures asset managers have long faced from rising regulatory and technology costs, competition, changing product demand and fee compression from the growth of passive investing. Up until now, firms have been able to ride these pressures through a sustained period of growth to their assets under management (AUM) and trimming around the edges to etch out efficiency savings.
When AUM growth stalled in 2018, many firms realizing that their current structures were unsustainable, started reviewing their operating models and preparing to make radical changes to future proof their businesses.
Outsourcing of core front-office functions such as trading desks and foreign exchange has become a popular strategy among smaller and medium-sized firms. Yet, some larger firms are heading in the opposite direction, insourcing one specific function.
As disclosed in a March 29 filing, Fidelity, the world’s fifth largest asset manager by AUM took the decision to bring its securities lending operations in house to compensate for the firm’s decision to offer zero-fee index funds.
I often refer to securities finance as the biggest market nobody has heard of. It is a market that generated $10.3 billion in revenue for lenders in 2018 according to FIS’ Astec Analytics. It is a small margin operation – one or two basis points per transaction – but if you manage the volume of assets as Fidelity does, it all adds up. As reported recently, Fidelity and its peers like Vanguard, Dimensional Fund Advisors and Blackrock all pulled in more than $100 million each from their securities lending programs.
As an asset manager considering insourcing its securities financing, there are number of factors to assess before making the decision.
Increasing supply but stagnating demand
There are two sides to the securities finance picture currently. We are seeing new lenders enter this market which is driving an increase in supply. Yet demand has stalled. This ultimately results in more players competing for the same pie and the slices are getting smaller.
There are plausible reasons for the slower demand growth. One is the global economic outlook has created uncertainty in the market, whether it is the US-China trade negotiations or Brexit uncertainty, all can have an impact. Secondly, regulation has preoccupied participants in the securities finance market recently, yet as understanding of these regulations become clearer, focus is now turning to new product innovations and offerings in new markets.
Availability of technology and data
Like many other operations impacting capital markets, effective securities lending is now being driven by the collection and use of data. Initially driven by new regulation, market participants have invested in harmonizing systems to source, collect and reconcile data to make better trading decisions.
Now, that investment is also enabling the deployment of advanced technology, such as a machine learning, which feeds off the higher quality and volume of data for insight discovery. Firms can also use robotics to automate upwards of 90 percent of their securities lending operation, making it a far less manual and more efficient than previously possible. With the increasing proliferation of advanced technology, the barriers to entry to the securities finance market are coming down, enabling those that may have previously relied on service providers to look at undertaking this activity themselves.
Regulatory drivers
As with any corner of capital markets, the ramp up of regulation since 2008 has had a profound impact on securities finance. The Securities Financing Transaction Regulation (SFTR) regulation goes live on April 11, 2020 and requires firms to report on up to 155 data fields on a T+1 basis. A past lack of harmonization in the industry means collecting this data, which may come from numerous sources and booking systems, has been a mammoth task.
Phase five and six of the Uncleared Margin Rules (UMR) also need to be considered for buyside firms, who will have to assess how to support more detailed margin management. As a result, UMR will increase the demand for high-quality liquid assets (HQLA) to meet initial margin (IM) calls, which will have a consequential knock-on impact for securities lending. The impact of UMR is expected to offset some of the stagnating demand for other asset types, which may well play to the advantage of some of the larger asset managers with significant holdings in HQLA such as G7 debt.
Asset managers should also consider their self-regulation as part of their decision-making process. Economic, Social and Governance (ESG) considerations are having an increasingly significant effect on the setting of investment objectives. Taking direct control of your own securities lending program can offer additional controls that could reinforce the implementation of an asset managers ESG principles.
Disintermediation of traditional transaction chain
Disintermediation of the securities lending market has long been prophesized, yet to achieve this in any industry, barriers to entry must be lowered. Doing so in the cash equities market, where we have seen the rise of low cost online only brokerages, is one thing. Achieving the same impact for a complicated borrow and loan market, is another.
We are starting to see disintermediation of inefficiencies, whether they be technological changes affecting straight-through processing rates or the broader structural changes to the traditional players in the transaction chain.
Does it make economic sense it insource securities lending
The question of insource or outsource to an agent lender often comes down to how quickly and easily a firm can build an in-house securities lending shop that can operate at its maximum potential. Third-party vendors now have open source platforms which be implemented and integrated with disparate systems seamlessly and at low cost which bring down the barriers of entry for asset managers.
Firms that are considering insourcing securities lending should also consider a wider project scope. A firm already doing cash management through repo, can easily bolt on a securities lending operation, but should also be considering incorporating these activities with their derivatives collateral management system. For those firms who able to align different businesses to create one platform that can service different operations such as securities lending, derivatives and repo, the economic benefits of insourcing are hard to ignore.
