At the IMN Beneficial Owners conference in London this September, SunGard Analytics presented figures showing why there is a global trend towards specials, chiefly, the disproportionately larger revenues when compared to the size of the market.
SLT: What is the global picture for specials at the moment?
Tim Smith: Since the 2008 crisis, securities lending has become on a global basis more of a specials than a GC based industry, meaning people are looking at the intrinsic value of the securities being lent. However, there are important regional differences in terms of GC versus specials around the world and the reason behind that is usually to do with collateral.
The biggest market in the world is the US, where cash is king and the choice of collateral since revenue is generated through cash reinvestment. In North America, in terms of loan volume, the GC amount outstanding in early October was about 85 per cent of the total loan, with GC being defined as anything earning less than 25 basis points. In Europe, the split was lower, it is less than 70 per cent GC based, while in Asian markets excluding Japan, the actual loan volume of GC versus specials is 30 per cent.
That is quite a relevant metric to have in mind because intuitively it has always been the case that securities lending outside of North America has always been about the security being lent, consequently every security that is borrowed tends to be defined as 鈥渟pecial鈥�.
SLT: What does the revenue picture look like?
Tim Smith: That gets quite interesting as well because the revenues turn those percentages around. If you are looking at North America, GC accounted for less than 20 per cent of revenue, so it turns the whole dynamic on its head, similarly in Europe, where revenue from GC stands at just under 30 per cent, while in Asia [excluding Japan], it is around five per cent.
That tells you a lot about the relative maturity of the markets and the nature of the business, how it has been established and conducted. In the US market, participants take a holistic view of securities financing, the cash reinvestment is taken as part of the whole trade and transaction, so there is a whole lot of talk about yield, yield on the cash, and that is historically the way the market has matured.
Europe is a sort of halfway house, where, although there are mature markets, there is a desire to take GC balances down in order to lodge elsewhere as non-cash collateral. It is an inbuilt market outside of cash reinvestment. European players are not actually borrowing GC to get cash to reinvest, but borrowing GC names cheaply in order to use as collateral.
When you look at Asian markets [excluding Japan], participants are actually looking to perhaps move from more exotic type of derivatives transactions to put on positions to more mainstream securities lending, but they have to pay up for those rates - everything is extremely special, extremely new. When you throw Japan back into the mix, the dynamics tend to look more like Europe.
SLT: What opportunities and challenges do these dynamics present?
Tim Smith: In terms of government debt, rates charged for borrowing when governments are under pressure is very much the same as the way a company鈥檚 securities would trade on the securities lending market if that company was under pressure.
What we have seen though in the earlier days in the securities lending data was that the rates in the markets that were the first to have trouble, for example, Greece, Ireland and Portugal, seem to have spiked more quickly, subsequently as more markets became more troubled, such as Spain and Italy, their rates in terms of borrowing weren鈥檛 quite so high as people got used to the fact that countries can be in trouble.
In the emerging markets, there are usually access products by way of swaps or derivatives - the earliest methodology was American Depositary Receipts (ADRs) or Global Depositary Receipts (GDRs). Shorting the ADR is still a fairly big business. Exchange-traded funds (ETFs) are one method of shorting without borrowing and lending the underlying shares in those markets, but, as the emerging markets come on board, we have found that the rates for borrowing the securities in the emerging markets tend to come down from high fee rates to much lower rates more quickly than in the developed markets.
SLT: What does the data say with regards to specials management?
Tim Smith: The data tells me that specials have taken over in importance, participants are focusing more on specials than GC lending. Behind that, if you look at the US charts for example, you see balances of volume on loan have gone down, but the rates overall in North American markets have just remained stable but gone up quite a bit, which implies that people are borrowing less but are paying more.
But what I want to stress in terms of the specials management, what we are seeing from all of the stakeholders in the securities financing process is that there is great demand for more hands on control and quicker rerating of outstanding transactions should they become more or less special.
That is one of the reasons why SunGard came out with an intraday service, participants want the rates now and we are finding that demand from both brokers and lending agents, but rather interestingly, from beneficial owner holders of securities as well. They want to have a bigger input to and control of their securities lending business.
SLT: How do you see this trend playing out?
Tim Smith: One cannot bank on there being specials every year, and that is one of the strange things about brokers bidding on borrowing a portfolio - it is very difficult because you don鈥檛 know what M&A activity will be out there or what dividends are going to be charged.
In 2009 in the US, the Citibank trade was the biggest of all time, it created $1.5 billion in income out of some $15 billion globally just on the one transaction. Obviously there are different areas to discuss about predicting company takeovers and that usually falls within the purview of areas outside of the securities financing desks. It is the latter that Astec Analytics supports through its price discovery and performance benchmarking technology. Whilst historical data analysis is good for establishing market signals and trends, predicting M&A activity is different and a more subjective business.
There are many variables in terms of managing a specials operation, so going forward it is very difficult to make hard and fast rules but certainly participants already feel the need for market information. For example, there is a large dispersion in the rates between borrowing for a longer period of time cheaply versus borrowing over a short period of time expensively - there is an overall potentially similar amount of generated income but in a different timescale.
Participants have to manage the rates, there was some 鈥渇lirtation鈥� on the asset management side in terms of looking to see what stocks were hot and buying those securities into a portfolio for the whole basis of lending those securities to generate income, but that is not a generally accepted tenet of investment management. It is probably not wise to buy and hold securities just in order to generate securities lending income, meaning, if there is a good economic sound investment reason for buying those securities then that should not be outweighed by anything earned from securities lending.
SLT: How do you see the specials market developing?
Tim Smith: In terms of ebbs and flows of specials lending, as it is driven by market conditions, it is a very reactive business, which is why GC entered the picture. Now, with the problems that were encountered in cash collateral reinvestment, participants are looking much more at specials only.
I think the focus on specials lending, or a more pragmatic approach, is going to be prevalent globally in terms of overall balances, North America is still by far the biggest market in the world, Europe is still fairly seasonal in its nature while Asia-Pacific [excluding Japan] is very much a specials only market.
All eyes are on what potentially will happen in China and India once those markets really open up. Again there will be the opportunity to take advantage or maximise interest in specials activity in those two markets. And, not to forget Latin America , where Brazil particularly shows high levels of interest. I am seeing a continued focus on intrinsic lending, certainly for the next two or three years. Later down the road, as people become more comfortable with any controls in place with regards to different sorts of collateral, maybe GC will get back into flavour.
Also to take into consideration is that, in the past, borrowers used to guarantee a certain amount of GC balances with big lenders in order to get an allocation of specials and that whole dynamic has rather broken down over the last couple of years. We may get back to that dynamic but not soon.
SLT: How are regulations impacting the industry?
Tim Smith: The trouble with the regulations, in terms of the desire for more transparency and control in the areas of short selling, is just as the securities lending business is different around the world so too regulators have different viewpoints.
Everyone has a different viewpoint in terms of what they want and feel they need to have out of securities lending and transparency, be it risk, return or reward. Sometimes, regulators will get hung up on associated activities, like cash collateral reinvestment, but securities lending itself is fairly well governanced right now, rules are usually coming out in the areas of short selling and cash collateral reinvestment.
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