Securities Lending: A European Viewpoint

As featured in Securities Finance Times, Issue 303

How do you assess the performance of European securities lending markets over the past 12 months?

Demand for European sovereign bonds fared well in 2021 with on-loan volumes and fees increasing. This was most prevalent towards the end of the year as further lockdown measures led to subdued economic activity, prompting a flight-to-quality bid for core sovereign bonds. In addition, a collateral crunch became apparent into year-end as sovereign bonds were in strong demand from market participants, with rates trading deeply into negative territory over the year-end reporting date. This bond scarcity eventually drove a significant specials premium, principally in the German curve, prompting the Deutsche Finance Agency to intervene and increase the outstanding nominal of the cheapest in order to calm market conditions.

Aside from sovereign bonds, demand for loans of corporate bonds increased as the inflationary environment resulted in higher funding costs. The Central Securities Depositories Regulation (CSDR) Settlement Discipline Regime also came into effect in Q1 2022. This may have meant that some lenders felt less comfortable lending bonds with liquidity challenges. 

Equity lending has been a more challenging environment over the past 12 months. Through 2021 the upward trajectory of European equity markets saw investors maintain a greater net long bias within their investment portfolios, resulting in softer demand and a weaker specials environment.

However, in the early part of 2022 we have seen a steep reverse in equity market trends, with heightened volatility amid sharp declines in asset valuations. Increased geopolitical tensions, surging inflation and aggressive tightening of monetary policy have all contributed to a risk-off approach. Hedge funds looked to de-gross equity exposures, again translating to weaker borrower demand. Capital raising activity has been one good source of borrower demand. With firms’ balance sheets weakened through the pandemic period and a low interest rate environment, we observed an increased number of companies coming to market to raise cash, creating opportunities for securities lending activity. Short interest across those sectors most exposed to COVID-19 lockdowns increased supply chain disruption and surging commodity prices have also been prominent themes.

In which European markets (by jurisdiction, asset class) do you identify strongest opportunities for growth of your lending business?  

We expect credit markets to be impacted as the growing inflationary environment gives way to recessionary fears. Consequently, demand for corporate bonds is likely to continue to push lending fees higher. This is likely to be mirrored in emerging market issuance as higher funding costs, supply chain disruptions and heightened geopolitical risks pressure asset valuations.

In the equity space, we see Saudi Arabia as a new market with strong growth opportunities. With a regulatory framework now in place, and significant demand materialising, we think this is a really exciting opportunity to be at the forefront of a rapidly developing market and expect to see an increase in activity in the market before the year end.

Global financial markets have been subject to major fluctuations in liquidity and market pricing over the past two years, with current geopolitical instability following close on the heels of the Covid pandemic. What pressures and opportunities has this created for your securities lending business?  

Borrowing counterparts are more focused on sourcing High-Quality Liquid Assets (HQLA) in term maturity tenors. We have seen rising demand to upgrade lower-rated or less-liquid assets for sovereign bonds through COVID-19 and the most recent period of geopolitical instability. In addition, we have continued to see a shift in borrower demand to more targeted lending. Borrowing counterparts are becoming more sensitive to capital usage and, in particular, to risk-weighted assets (RWA) - a measure to determine the risk of trading exposures and subsequent capital required.

What investments and adaptations to working practices have you made to sustain and grow your European securities lending activity in this environment?   

As a consequence of the capital focus, our borrowing counterparts have sought more bespoke trading routes, including pledge and other capital efficient lending structures. We have focused on developing this as a key area as we recognise that adapting to changes in demand themes is crucial to keeping our agency lending program relevant and competitive.

What impact will the potential for monetary tightening over the coming 6-12 months have on lending opportunities and collateralisation strategy in Europe? 

Collateral scarcity is an area of concern. We have already observed a challenging environment, which will likely persist once the later phases of the Uncleared Margin Rules (UMR) are fully implemented and digested. As such, clients require a full suite of options, allowing them to make quick decisions as to the best usage of their assets. Northern Trust is creating an ecosystem where expanding capabilities within the securities finance space can be harmonized to achieve maximum portfolio optimization.

What expectations do your clients have from you as a service provider in supporting their commitment to sustainable lending and borrowing? Have recent market conditions and geopolitical stresses had an impact on demand for ESG-compliant lending solutions? 

In one word, flexibility. Our client base has a diverse range of views and requirements in respect of their approach to sustainability and ESG matters. Our focus is to ensure we can meet that diversity with optionality. Recent events have brought added attention and a shift in approach for some firms, but the level of importance of this topic to our clients was already extremely high in the preceding years.

How do you assess the outlook for European securities lending markets for the remainder of 2022 and into 2023? 

With market volatility still very high, and much uncertainty in the macroeconomic and geopolitical environment, it is difficult to see a big change in hedge fund risk appetite. It is expected short interest will continue to be seen in industries most impacted by rising interest rates, supply chain concerns and persistent inflation. With recession risks recently starting to replace interest rate risks we should see the safe-haven bid maintained for sovereign bonds, providing fee premium for the most liquid lendable assets. In addition, this is likely to continue to push demand and lending fees higher for credit and emerging market issuance, boding well for fixed income lending revenue.

What is top of your development priorities to capitalise on these market conditions? 

Market and collateral expansion are key to driving a successful lending program. Opening up new market opportunities to drive revenues and offering flexible collateral schedules will be crucial to capturing new business and generating the best returns for our clients. We continue to invest heavily in our technology, with a focus on automation, flexibility and enabling our clients to make the best possible data-driven decisions for their portfolio.

This marketing communication is issued and approved for distribution in the United Kingdom and European Economic Area by The Northern Trust Company, London Branch (‘TNTC’) or Northern Trust Global Services SE (‘NTGS SE’). TNTC is authorised and regulated by the Federal Reserve Board; authorised by the Prudential Regulation Authority; subject to regulation by the Financial Conduct Authority and limited regulation by the Prudential Regulation Authority. NTGS SE is authorised by the European Central Bank and subject to the prudential supervision of the European Central Bank and the Luxembourg Commission de Surveillance du Secteur Financier.  View full disclaimer