Securities Finance Equity Market Update

Securities Finance: Equity Market Update

March 2016
Robert Chiuch   |   Managing Director, Global Head of Equity & Fixed Income Finance, BNY Mellon Markets
Simon Derrick   |   Chief Currency Strategist, Head of the BNY Mellon Markets Strategy Team
Richard Marquis   |   Managing Director, Regional Head of Equity Finance, Americas, BNY Mellon Markets
Paul Solway   |   Managing Director, Regional Head of Securities Finance, Asia Pacific, BNY Mellon Markets
Simon Tomlinson   |   Managing Director, Regional Head of Equity Finance Trading, EMEA, BNY Mellon Markets
Phil Zywot   |   Managing Director, Regional Head of Equity Finance, Canada, BNY Mellon Markets

Panelists at a BNY Mellon roundtable in January of 2016 took a closer look at recent market trends in the areas of equity finance and equity securities lending. The discussion focused on the trends and drivers around recent market volatility and the resulting impact on the equity finance markets across the globe.

3 Key Themes

  • Underlying drivers of recent market volatility are connected to global monetary policy events which are influencing the value of the U.S. dollar and in turn, the commodities and equities markets.
  • It’s been a challenging environment for generating earnings on securities lending portfolios, however commodity sector equities are experiencing increased demand for borrowing.
  • Collateral flexibility has become more important as demonstrated by the growing trend toward expanded collateral options in recent years. Borrowers are increasingly utilizing their long inventory to meet collateral needs and seeking term options in conjunction with that.

Key Highlights

The Drivers of Market Volatility

What is driving the extraordinary market volatility seen in a wide range of assets across the globe? Over the last 18 months we’ve seen far more highly volatile days within the foreign exchange market and more in the asset markets than we have recently come to expect. While a lot of attention is given to the events in China, oil and the performance of the European asset markets, a retrospective view of the last 15 years provides a good backdrop.

  • Monetary policy changes impacted market volatility. The ultra-easing of U.S. monetary policy from 2002 – 2014, particularly when the Fed put its foot to the floor on monetary policy, resulted in strong gains in commodities. Oil prices rose. Emerging markets also benefitted from the cheap U.S. dollar. China's foreign exchange reserves grew.

Chart 1. The USD Becomes Increasingly Attractive

Chart 1.  The USD Becomes Increasingly Attractive

Source: Federal Reserve/Reuters

  • With the European Central Bank (ECB) negative deposit rate in the summer of 2014, the U.S. dollar started appreciating. Oil prices weakened, and there was a rise in volatility in the asset markets and the currency markets. China’s foreign exchange reserves began to decline.
  • Given this trend, the volatility during the first weeks of 2016 becomes easier to understand.

 

“I think that when we look back to where we are at the end of 2015 and the start of 2016, we’ll identify the key to understanding the crisis in December having both the Fed hiking rates and the ECB easing policy, making the dollar even more attractive. Once we get that, then I think we can see a bit more clearly why the events of the last few weeks have just happened.”

—Simon Derrick, Chief Currency Strategist

 

It’s Been a Challenging Year

Why do we concern ourselves with the underlying market values or asset performance? There are major themes that center around asset value, but the most direct relationship is that fees earned on lent securities and the value of collateral received are based on the underlying asset values.

  • 2015 was a challenging year from a macro perspective. Those challenges have rolled into 2016. Market valuations, distressed securities and the liquidity related to those, concerns around global growth and ultimately monetary policy and the divergence in policy between certain developed nations all impact the securities finance business.
  • These forces can affect the ability of borrowers to source needed securities and asset owners to earn incremental revenue on their portfolios and enhance returns.
  • U.S.: The market correction in the third and fourth quarters of 2015 impacted borrowers, especially prime brokers. The internal securities held by these borrowers were sold off which reduced their equity positions for internal short covering and also reduced the internal positions that they could use as collateral. The result was an increased reliance on borrowing versus cash. The Fed move in December also had an impact. The rate hike was well anticipated such that many players in the lending market really hadn’t had much exposure given the fact that it was really the first upward move in eight years. It helped returns. The dislocation of loan vs reinvestment allowed for a widening of spreads and enhanced our ability to gain a level of intrinsic spread in the hard to borrow space. In addition, from North America all the way down through to Latin America some of the larger revenue generators came from the commodities and commodities related space.

 

“It helped returns - the dislocation of loan vs reinvestment allowed for a widening of spreads and enhanced our ability to gain a level of intrinsic spread in the hard to borrow space.”

— Richard Marquis,U.S. Regional Trading Head

 

  • EMEA: 2015 was a tough year in terms of the Euro-zone exchange rate which had a noticeable impact on securities lending earnings. Euro-zone related assets experienced a 17% decline in 2015 vs. 2014, due to foreign exchange depreciation which was only marginally tempered by the increased dividend payouts in 2015. Related to the negative interest rate environment in EMEA, cash collateral reinvestment was challenging, but due to accommodative monetary policies, we have seen a trend of opportunities to do more business vs. cash collateral. In addition, Europe has certainly seen a flurry of directional plays in the commodity and natural resource sector.

 

“Last year was certainly a tough year in terms of the Euro-zone exchange rate for EMEA which had a noticeable impact on securities lending earnings.”

— Simon Tomlinson,EMEA Regional Trading Head

 

  • CANADA: The Canadian economy is closely linked to resources, specifically oil, so with the core economic numbers out of China, the Canadian dollar fell over 19% versus the U.S. dollar in 2015. Along with the TSX Composite Index falling over 11%, there was an impact on the Canadian dollar-based revenues and balances. This was more than offset by the increase in merger and acquisition (M&A) activity and the directional plays that took place in the Canadian equity space in 2015. The Bank of Canada has been following a divergent monetary policy from that of the U.S.. Last year it cut rates twice, seeking to be proactive in heading off a recession due to the falling commodity prices.

 

“The Bank of Canada has been following a divergent monetary policy from that of the U.S.”

— Phil Zywot, Canada Regional Trading Head

 

  • APAC: With respect to currency implications on earnings, Asia is home to two out of the three largest markets globally by market capitalization (i.e., Japan and Hong Kong). Japan remains a mature liquid and dominant lending market for Asia. When the yen depreciated 20% over 2015, earnings in dollar terms were impacted significantly. Asia is also one of the pure fundamental regions. That’s one of the strongest plays. So the China effect and fluctuations in the commodities sector are important and affect earnings right down the line from shipping to airlines, etc.

 

“Asia is home to two out of the three largest markets globally by market capitalization.”

— Paul Solway, APAC Regional Trading Head

 

The Trend Toward Collateral Flexibility and Term Trades Collateral plays a vital role in a dynamic securities finance marketplace, and agent lenders need to monitor the ratio of cash to non-cash collateral.

  • Equity collateral has been growing in popularity in recent years and has a favorable risk profile in many instances.
  • Equity is important for borrowers, especially when acting as prime brokers. They can use their long inventory as collateral, providing collateral and borrowing securities against that instead of looking to raise cash and/or raise cash to purchase Treasuries.
  • Rolling term trades, or evergreen trades, are also gaining in popularity. An evergreen trade resets every day for a set term. Regulation is the driving force behind these trades as they help borrowers to cover their Liquidity Coverage Ratio (LCR) requirements. The term for these trades can vary from 30 days to 95 days. The Net Stable Funding Ratio (NSFR), another regulatory initiative due to debut in January 2018, will have a further impact on evergreen trades, pushing the term further out the curve.
  • Evergreen trades create benefits for the borrowers and opportunities for our securities lending clients. They are efficient and cost-effective. However, there is a great deal of complexity in the marketplace relating to evergreen pricing. Pricing variables include the securities on loan, the collateral and the type of counterparty. It's an evolving situation especially since not all of the regulations have been finalized.

Chart 2. Cash vs. Non-Cash Collateral Market Trends

cash vs noncash us

In the U.S., approximately half of the non-cash collateral can be attributed to the pledging of equities.

cash vs noncash emea

Europe has usually been tilted towards non-cash collateral, but this is changing largely because of quantitative easing. Europe now has a significant cash collateral market.

cash vs noncash apac

APAC has a significant non-cash bias.

cash vs noncash canada

Ten to fifteen years ago the Canadian market was a non-cash market, with about 90% of the Canadian market non-cash (mainly sovereign debt as collateral) and 10% cash. There has been a shift over the last few years with non-cash collateral now comprising about 85%, with equity collateral making up 20% of the non-cash space.

Source: Internal BNY Mellon data

So What Are the Key Takeaways for the Remainder of 2016? Follow the actions of the Fed and the European Central Bank in the face of this market volatility. Additionally, it will be interesting to follow the direction of China’s currency policy which can add to volatility and feed into the broader assets market.

 

“There’s never been a more important time to engage an agent that understands the pace of innovation and the level of investment required to achieve the best outcome. We’re talking about significant financial, human and technological resource requirements that make that come together.”

— Robert Chiuch, Global Head of Equity & Fixed Income Finance

The views expressed within this article are those of the author only and not those of BNY Mellon or any of its subsidiaries or affiliates.

BNY Mellon is the corporate brand of The Bank of New York Mellon Corporation and may be used as a generic term to reference the corporation as a whole and/or its various subsidiaries generally. This material and any products and services may be issued or provided under various brand names in various countries by duly authorized and regulated subsidiaries, affiliates, and joint ventures of BNY Mellon, which may include any of the following. The Bank of New York Mellon, at 225 Liberty St, NY, NY USA, 10286, a banking corporation organized pursuant to the laws of the State of New York, and operating in England through its branch at One Canada Square, London E14 5AL, UK, registered in England and Wales with numbers FC005522 and BR000818. The Bank of New York Mellon is supervised and regulated by the New York State Department of Financial Services and the US Federal Reserve and authorized by the Prudential Regulation Authority. The Bank of New York Mellon, London Branch is subject to regulation by the Financial Conduct Authority and limited regulation by the Prudential Regulation Authority. Details about the extent of our regulation by the Prudential Regulation Authority are available from us on request. The Bank of New York Mellon SA/NV, a Belgian public limited liability company, with company number 0806.743.159, whose registered office is at 46 Rue Montoyerstraat, B-1000 Brussels, Belgium, authorized and regulated as a significant credit institution by the European Central Bank (ECB), under the prudential supervision of the National Bank of Belgium (NBB) and under the supervision of the Belgian Financial Services and Markets Authority (FSMA) for conduct of business rules, and a subsidiary of The Bank of New York Mellon. The Bank of New York Mellon SA/NV operates in England through its branch at 160 Queen Victoria Street, London EC4V 4LA, UK, registered in England and Wales with numbers FC029379 and BR014361.  The Bank of New York Mellon SA/NV (London Branch) is authorized by the ECB and subject to limited regulation by the Financial Conduct Authority and the Prudential Regulation Authority. Details about the extent of our regulation by the Financial Conduct Authority and Prudential Regulation Authority are available from us on request The Bank of New York Mellon SA/NV operating in Ireland through its branch at 4th Floor Hanover Building, Windmill Lane, Dublin 2, Ireland trading as The Bank of New York Mellon SA/NV, Dublin Branch, is authorised by the ECB and is registered with the Companies Registration Office in Ireland No. 907126 & with VAT No. IE 9578054E. The Bank of New York Mellon, Singapore Branch, subject to regulation by the Monetary Authority of Singapore. The Bank of New York Mellon, Hong Kong Branch, subject to regulation by the Hong Kong Monetary Authority and the Securities & Futures Commission of Hong Kong. If this material is distributed in Japan, it is distributed by The Bank of New York Mellon Securities Company Japan Ltd, as intermediary for The Bank of New York Mellon.  Not all products and services are offered in all countries.

The information contained in this material is intended for use by wholesale/professional clients or the equivalent only and is not intended for use by retail clients. If distributed in the UK, this material is a financial promotion.

This material, which may be considered advertising, is for general information purposes only and is not intended to provide legal, tax, accounting, investment, financial or other professional advice on any matter.  This material does not constitute a recommendation by BNY Mellon of any kind. Use of our products and services is subject to various regulations and regulatory oversight. You should discuss this material with appropriate advisors in the context of your circumstances before acting in any manner on this material or agreeing to use any of the referenced products or services and make your own independent assessment (based on such advice) as to whether the referenced products or services are appropriate or suitable for you. This material may not be comprehensive or up to date and there is no undertaking as to the accuracy, timeliness, completeness or fitness for a particular purpose of information given. BNY Mellon will not be responsible for updating any information contained within this material and opinions and information contained herein are subject to change without notice.  BNY Mellon assumes no direct or consequential liability for any errors in or reliance upon this material.

This material may not be distributed or used for the purpose of providing any referenced products or services or making any offers or solicitations in any jurisdiction or in any circumstances in which such products, services, offers or solicitations are unlawful or not authorized, or where there would be, by virtue of such distribution, new or additional registration requirements.

The terms of any products or services provided by BNY Mellon to a client, including without limitation any administrative, valuation, trade execution or other services shall be solely determined by the definitive agreement relating to such products or services. Any products or services provided by BNY Mellon shall not be deemed to have been provided as fiduciary or adviser except as expressly provided in such definitive agreement. BNY Mellon may enter into a foreign exchange transaction, derivative transaction or collateral arrangement as a counterparty to a client, and its rights as counterparty or secured party under the applicable transactional agreement or collateral arrangement shall take precedence over any obligation it may have as fiduciary or adviser or as service provider under any other agreement.

Pursuant to Title VII of The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and the applicable rules thereunder, The Bank of New York Mellon is provisionally registered as a swap dealer with the Commodity Futures Trading Commission (“CFTC”) and is a swap dealer member of the National Futures Association (NFA ID 0420990).

BNY Mellon (including its broker-dealer affiliates) may have long or short positions in any currency, derivative or instrument discussed herein. BNY Mellon has included data in this material from information generally available to the public from sources believed to be reliable. Any price or other data used for illustrative purposes may not reflect actual current conditions. No representations or warranties are made, and BNY Mellon assumes no liability, as to the suitability of any products and services described herein for any particular purpose or the accuracy or completeness of any information or data contained in this material.  Price and other data are subject to change at any time without notice.

Rates: neither BNY Mellon nor any other third party provider shall be liable for any errors in or delays in providing or making available the data (including rates, WM/Reuters Intra-Day Spot Rates and WM/Reuters Intra-Day Forward Rates) contained within this service or for any actions taken in reliance on the same, except to the extent that the same is directly caused by its or its employees’ negligence. The WM/Reuters Intra-Day Spot Rates and WM/Reuters Intra-Day Forward Rates are provided by The World Markets Company plc (“WM”) in conjunction with Reuters. WM shall not be liable for any errors in or delays in providing or making available the data contained within this service or for any actions taken in reliance on the same, except to the extent that the same is directly caused by its or its employees’ negligence.

The products and services described herein may contain or include certain “forecast” statements that may reflect possible future events based on current expectations. Forecast statements are neither historical facts nor assurances of future performance. Forecast statements typically include, and are not limited to, words such as “anticipate”, “believe”, “estimate”, “expect”, “future”, “intend”, “likely”, “may”, “plan”, “project”, “should”, “will”, or other similar terminology and should NOT be relied upon as accurate indications of future performance or events. Because forecast statements relate to the future, they are subject to inherent uncertainties, risks and changes in circumstances that are difficult to predict.  iFlow® is a registered trademark of The Bank of New York Mellon Corporation under the laws of the United States of America and other countries.

This document is intended for private circulation.  Persons accessing, or reading, this material are required to inform themselves about and to observe any restrictions that apply to the distribution of this information in their jurisdiction.

Neither BNY Mellon nor any of its respective officers, employees or agents are, by virtue of providing the materials or information contained herein, acting as an adviser to any recipient (including a “municipal advisor” within the meaning of Section 15B of the Securities Exchange Act of 1934, as amended, “Section 15B”), do not owe a fiduciary duty to the recipient hereof pursuant to Section 15B or otherwise, and are acting only for their own interests.

All references to dollars are in US dollars unless specified otherwise.

This material may not be reproduced or disseminated in any form without the prior written permission of BNY Mellon. Trademarks, logos and other intellectual property marks belong to their respective owners.

The Bank of New York Mellon, member FDIC.

© 2016  The Bank of New York Mellon Corporation. All rights reserved.