Don D’Eramo, Head of Securities Lending at RBC I&TS, says discussing your goals and constraints with your agent lender is the best way manage a programme
What are the key regulatory concerns at the moment?
Don D’Eramo: I always look at it through the lens of the client. While we embrace regulatory change as it makes the industry stronger, which benefits everyone, there are definitely impacts to activities that are discretionary for beneficial owners. We really keep an eye on regulatory caps and ratios, such as liquidity coverage ratio (LCR), net stable funding ratio (NSFR), and Securities Financing Transactions Regulation (SFTR).
The capital ratios manifest in changing demand. The growth of fixed income over the past few years is directly correlated to demand for high quality liquid assets (HQLA) and collateral transformation, whether for new margining requirements or capital improvement. We definitely see growth in demand for term, where possible HQLA for term, and obviously growth in borrowing fixed income on term versus equities.
The SFTR draft technical standards are now finalised and beneficial owners will clearly look to their agents to manage these for them in a very transparent way. The overarching consideration is how onerous a regulation has become – what are the costs and how do they manifest themselves within the business? The fear is that a regulation impacts costs and therefore potentially market liquidity.
Should beneficial owners be concerned about SFTR?
D’Eramo: Clarification on SFTR, in terms of how and what you report, will soon appear. The timing for when an entity must comply ranges between October 2018 and possibly mid-2019. Agent lenders have to consider how we allocate collateral as well, because variables such as timestamping become important. But the challenges are not insurmountable. The current agent lender disclosure (ALD) model needs to be enhanced to work with financial transaction reporting, as ALD is based on the settlement date and SFTR the trade date.
How is regulation affecting supply and demand?
D’Eramo: NSFR definitely contributes to the trend of providing borrowers regulatory solutions. We could potentially term HQLA assets further out, as opposed to the current relatively close one to six-month durations. Sometimes regulations, with good intentions, have contradicting consequences. In Europe capital regulations are pushing demand for term loans but Ucits regulations don’t permit the supply, so they are not able to take advantage.
Are there differences between how agent lenders handle these regulatory challenges?
D’Eramo: If an underlying beneficial owner is bound by a certain regulation – whether it’s the national instrument, such as the Ucits Directive or 81-102 for Canadian mutual funds – I don’t believe there would be varying solutions. I’m also the president of the Canadian Securities Lending Association and we are engaging with regulators to look at changes that would open up demand for Canadian mutual funds.
But there’re other ways agents can have varying solutions. In Europe we’re seeing an interesting discussion around title transfer and the pledging of collateral. Potentially there will be a paradigm where the margin may be in a pledge format versus a loan in title transfer, which alleviates certain capital constraints from a counterparty perspective.
At RBC I&TS we like to engage with our counterparties and beneficial owners to understand how we can evolve our product. We’ve done that for pledge – we’re at the forefront of that structure and at the forefront of trying to provide demand opportunities in a more opportunistic paradigm to our custodial clients, offering them transactional opportunistic value when it arises.
How can beneficial owners increase the attractiveness of their porfolios amid so much supply?
The key tenet of the RBC I&TS lending programme is to identify demand opportunities and marry them to the client’s collateral constraints
D’Eramo: There’s something like $24trn lendable and roughly $2.9trn on-loan, so supply has definitely increased. But demand also continues to evolve. One bucket is term and regulation- driven demand. There is continued growth in optionality, and where there’re sub-optimal allocations we can step in and optimise that for clients through collateral transformation. Equities are probably the fastest growing collateral asset class we’ve seen over the past couple of years; almost 50% of the $2.9trn is collateralised with noncash and it continues to grow.
The key tenet of the RBC I&TS lending programme is to identify demand opportunities and marry them to the client’s collateral constraints. We identify the objective of the client and structure their lending programme accordingly. We propose collateral profile changes required to capture demand trends. Not all clients want to follow these proposals, and some clients may not be able to due to regulatory constraints, but it’s important to play a leading role. Today a lot of clients opt for a very intrinsic value, opportunistic or minimum- spread mandate as opposed to a full-scope programme.
Are clients willing to pay more for indemnification or accept less of it in certain areas?
D’Eramo: We have a set, very rigorous risk culture around what and how we indemnify. We’ve been very economical in our revenue sharing structures, whether indemnified or non-indemnified. The last thing we want to do is re-price clients – it’s really about ensuring they understand what the indemnification means and the reason why it’s being offered.
For example, consider indemnifying government bonds versus government bonds – the value of an indemnity where the loans are potentially perfectly correlated with the collateral is very different from where you take the full breadth of collateral.
Not having indemnification doesn't work for everyone – but that’s not to say it has to. It just starts the more interesting discussion around what the client wants to achieve. Some are very happy with just an opportunistic approach, with low balances and high returns. Others may be more revenue-focussed and understand an indemnified programme with a broader collateral profile will achieve their goal.
Are you interested in using centrally cleared markets?
We like to engage with our counterparties and beneficial owners to understand how we can evolve our product
D’Eramo: MiFID II pushes the concept of best execution to the front and centre. Lending is obviously an over–the-counter (OTC) market, but cleared markets are something we are definitely focused on. We will ensure we meet MiFID requirements in the near future with a firm policy in place, which is relatively new to our business.
We are very close to the development of CCPs, or central counterparties. There will be a place for them within the industry – I’m surprised I still haven’t had a plethora of requirements from our counterparties to move to a cleared construct – but that may be because the infrastructure still isn’t where it needs to be. I believe that we will get there in certain markets or for certain transactions.
I’m not sure if we’re on the verge of them being adopted, but there’s more discussion. It is aligned with other changes such as the trend for term lending or using equities as collateral, and even new paradigms such as title transfer and pledge. There seems to be a lot more discussion and eagerness around those topics than CCPs. The sell side hasn’t really been pushing. However, there will definitely be a requirement for CCPs at some point so we need to ensure we can move to the new paradigm when it comes.
What muddles this is the infrastructure. In the US lending market, the largest, CCPs are not really a true industry construct yet. There is some dealer-dealer clearing but there really isn't anything for agents. Europe is obviously further down the road but even there our counterparties aren’t resolutely asking to use them.
How can beneficial owners benchmark their agents to make sure they are securing the best possible revenue?
D’Eramo: There’s definitely increased engagement with beneficial owners across the board. The top quartile beneficial owners – ones that have multiple agents or real economic size and sophistication – increasingly have direct relationships with benchmarking facilities, which we encourage. We use all the benchmarking data providers and make them available to our clients.
We don’t really look at the benchmarking data with our clients, comparing A to B, it’s about having a richer discussion about why their current performance may be under or over potential benchmarks, which begets discussion about their collateral profiles or trends in the market.
For beneficial owners the value of data is in pricing a special or warm security – there’s enough data out there to do that efficiently. But understanding and consequently tailoring their programme to meet those goals is how clients gain a holistic view. We ensure that it is transparent to their investment process, that they are not experiencing failed trades and receive reporting when and how they want it. It’s incumbent upon us to know the market and understand what’s driving it. Benchmarking is a supporting tool that we use to enrich the discussion, to help open up new markets and identify opportunities for clients where they may historically have been apprehensive.