Growth, challenges and new opportunities for securities lending in 2016

Deprived of their usual sources of yield, beneficial owners are increasingly looking to securities lending to add alpha.

By Soapbox

By Lance Wargo, Head of Agent Lending North America, BNP Paribas

Deprived of their usual sources of yield, beneficial owners are increasingly looking to securities lending to add alpha. However, the nature of agency lending is changing. In addition to higher demand, agency lenders are having to become more responsive to the needs of their clients.

The US interest rate opportunity

Increased costs and regulatory complexity have already led some banks to scale back their agency lending operations. Meanwhile others are committing new resources to staff, operations and technology. The question of balance sheet – who has it and who can use it – is central to the future of agent lenders.

However, while capital costs remain the primary consideration, the securities lending market has a major upside opportunity in 2016: the rise of US interest rates. Interest rate rises in the US would have a positive impact for beneficial owners, agent lenders, prime brokers and hedge funds alike.

The securities lending market has been hampered by an inability to generate revenue from conservative cash investments. Rising rates would give securities lenders the opportunity to implement a variety of strategies to reinvest cash and earn a better return than today.

A leading opportunity here is engaging in an interest rate mismatch lending and reinvestment strategy. This type of portfolio strategy is very client-specific and not appropriate for all securities lending participants, but is impactful from a revenue generation perspective.

Careful consideration should be given prior to implementing such a strategy, with beneficial owners and agent lenders working in tandem to design and customize a lending program based upon client risk parameters, portfolio assets and reinvestment guidelines. Liquidity parameters, funding diversification and risk management should also be considered prior to engaging in such a strategy.

While higher interest rates will present some interesting opportunities, it is imperative beneficial owners are comfortable with the adjusted risk return associated with this strategy.

Changes and Challenges

If you re-wind to the halcyon days of 2007-2008, lending was very “plug-and-play” for investors – a custodian would typically handle the securities selection process, and, soon after, the returns would begin to arrive.

The Global Financial Crisis changed all that; suddenly, investors wanted a separately managed, customized program, with the ability to dictate specific investment guidelines, or, in some instances handle the investing themselves.

The ability for lenders to tailor programs to a client’s specific risk characteristics has become a compulsory element. Naturally, a lot depends on whether a client views lending as a purely ancillary product—i.e., one that could help offset day-to-day operating expenses, for instance—or, by contrast, is amenable to increased risk exposure in order to help meet unfunded liabilities or generate additional alpha for the investment portfolio.

Accordingly, information earmarked for beneficial owners must be easy to understand and customized to their specifications; lenders should also hold regular discussions with CIOs to ensure that the structure of the lending program continually meets their guidelines. Additionally, having a diversified, risk-managed asset allocation covering a broad range of potential borrowers can help owners optimize their lendable supply, while also mitigating risk.

Participants also require top-shelf technologies to ensure streamlined lender-owner communications. The availability of advanced dashboard-based reporting mechanisms offer clients a more holistic view of the markets; for those with a higher risk appetite, tools such as stress testing allow owners to accurately access cash-reinvestment risk in real time.

Despite the regulatory headwinds which are making securities lending more complex and costly, I’m very positive on the outlook for the sector. The service provides a consistently positive revenue stream for clients and ongoing work will ensure the market continues to evolve safely and meet new regulatory requirements.