If pension funds, insurers and sovereign wealth funds were hoping to cash in on lending “high-quality” assets to those scrambling to meet tougher collateral requirements in 2014, they are likely to be disappointed.
The phasing in of the U.S. Dodd-Frank Act and its European equivalent EMIR (European Markets Infrastructure Regulation) over the next 18 months is expected to boost demand for assets like top-rated sovereign debt to back derivative trades.
But for all the industry warnings of a squeeze in supply—dismissed by regulators as a tactic to lobby for weaker rules— the amount of available collateral outstripped demand last year and things are unlikely to change much near term.
“People are still expecting this demand to come but there’s plenty of supply at the moment and until that comes under pressure, fees won’t rise appreciably,” said David Lewis, senior vice president at Sungard’s data firm, Astec Analytics.
If all derivative deals are forced to go through central clearing, where both parties would be asked to post collateral, some industry bodies have suggested it could lead to demand for new collateral of between $800 billion and $10 trillion.
Other new rules, also aimed at applying lessons from the 2007/09 financial crisis, will force banks to hold buffers of government debt to withstand shocks unaided.
That ought to be good news for the big funds, which tend to hold pools of such “safe”, low-yielding assets and many of which welcome a chance to earn more by lending them out.
Sungard said stock lending rose around 15 percent last year. The volume of bonds borrowed rose 20 percent, but fees earned by those lending them did not rise.
“If anything, we saw returns from government bond lending drop a little bit. The average return from a global bond lending programme is around 15 basis points (bps), so it’s not a massive revenue earner yet.”
Assets on loan are worth around $1.8 trillion globally and are roughly split 40:60 between bonds and equities, although the value on loan rises sharply during the dividend season.
Most bonds are borrowed for collateral or to help manage financing operations at banks, while stocks are mostly lent for market making or to proprietary traders such as hedge funds betting on a price fall.
Low-fee assets of below 20 bps—mostly-high quality debt borrowed for a short time—make up around 80 percent of total lending by volume, while the top-earning deals—sometimes in the hundreds of basis points—are largely from stock lending.
While U.S. derivatives clearing is already being phased in, the introduction of Europe’s equivalent EMIR rules will take longer and some suggest it could take several years for the full impact to be felt on collateral demand in Europe.
“We believe it will take a few years after all the initiatives are in place before you start to see some stress on eligible collateral,” said Nadine Chakar, head of product and strategy for BNY Mellon’s Global Collateral Services business.
At the same time, while regulations such as Basel III have led to a slight increase in demand from banks to “optimize” their balance sheets—typically swapping higher-quality bonds for their lower-quality assets—reduced post-crisis trading levels and heavy bond supply are acting to keep fees in check.
During the most recent earnings season, Europe’s leading investment banks all saw a slide in trade revenue as volumes fell, particularly in fixed income, currencies and commodities, helping to put a lid on collateral demand.
“For all the anticipated demand for HQLAs (high quality liquid assets), it is not really being reflected in the price the sell-side is prepared to pay,” said Mick Chadwick, head of trading for the securities lending business at Aviva Investors, which manages around 250 billion pounds ($410.95 billion) of assets.
The fee demanded by a lender varies according to a variety of factors, including asset quality and how long the borrower wants the asset for. For a trade involving safe-haven German debt, the typical price could be under 10 bps.
A meaningful spike from that level is unlikely in 2014 as long-term holders look to capture as much additional yield as possible in a world of low central bank interest rates.
“Beneficial owners have a positive desire for securities lending to help generate incremental returns. The challenge is on the demand side,” said Paul Wilson, global head of agent lending products at JPMorgan, citing the impact of macro economic activity by central banks, rising equity markets and the impact of new capital rules.
The new Basel III bank capital rules are prompting lenders to “deleverage” or rein back risky activities—which require more collateral—in order to reduce the overall need for expensive capital.
While there were some reasons to think demand may increase, for example from hedge funds adding leverage to engage in short-selling, it will likely be moderate, Wilson said.
“The outlook is a little bit more positive than it was in 2013, but I don’t see 2014 as a knockout year.”
($1 = 0.6084 British pounds)
(Reporting by Simon Jessop; additional reporting by Huw Jones; editing by Philippa Fletcher)