Looking ahead
09 January 2018
What to expect in 2018. Mark Barnard, Gareth Mitchell, Mark Jones and Andrew Dyson discuss what鈥檚 in store for the securities lending industry
Image: Shutterstock
MiFID II goes live in January, is the market ready? Will anything change?
Mark Barnard: Many market practitioners worked hard to meet the January deadline for the go-live and we believe the deadline was met by most. The pressing concern is the unknown level of remediation that will be needed. If firms were limiting their testing to ensure that they were second Markets in Financial Instruments Directive (MiFID II) compliant from day one, the level of 鈥榗lean up鈥� may be great and with this brings two challenges.
The quantum of remediation is potentially larger than if the initially desired level of testing had taken place and the extended period of clean up will result in staff that were allocated to non-MiFID work from January 2018 being retained and subsequently creating resourcing issues for other projects such as 色花堂Financing Transactions Regulation (SFTR).
Mark Jones: I think the securities lending market was largely ready for MiFID II. At Northern Trust, we took a centralised team approach for custody, securities lending, foreign exchange, brokerage and transition management to meet our obligations
for MiFID II.
While the main challenge for the market as a whole has been the scale of the regulation as it pertains to our individual products, our team approach ensured a consistent application across the organisation. I suspect that the range of solutions adopted across the market will look very different from firm to firm as a result of differing interpretations.
Gareth Mitchell: The objective of MiFID II is to improve investor protection, make markets more efficient and increase transparency. Although MiFID II imposes additional disclosure and compliance obligations on the agency lending businesses, we do not anticipate that there will be a material impact on the day-to-day provision of services. SFTR, which is due to come into effect in Q1 2019, will complement the transparency requirements imposed by MiFID, which currently excludes securities financing transactions. (SFTs).
The Brexit negotiations are in full swing. Given what we know now, do you expect the final deal (or lack of one) to significantly influence securities lending markets, either in the EU or globally?
Mitchell: Whilst the UK鈥檚 negotiations with the EU are still ongoing and the outcome is still unknown, market participants will have assessed potential impact on market access and are developing plans to ensure business continuity. A key point will be the availability of cross-border licenses or other arrangements within Europe which will underpin securities lending activities. Citi is well positioned to provide clients with continuity of service without disruption and provide support through the UK鈥檚 withdrawal from the EU without the assumption of a transition or implementation period.
Barnard: We see the biggest impacts of Brexit on securities financing markets being driven by loss of passporting, which could change the jurisdiction of the lending desk leading to fragmentation of liquidity and higher operational costs. Central counterparty services could also be split across the single market border, fragmenting clearing processes and reducing netting benefits.
The next phase of the over-the-counter (OTC) margin rules is also set for January. What has the implementation process been like in preparation for this latest deadline?
Barnard: Large firms are well versed in initial margin and variation margining processes so implementing foreign exchange (FX) forwards in January is 鈥渏ust another asset class鈥�, not to trivialise the work involved. But smaller firms have struggled, especially if they are margining for the first time. Some small firms have left it incredibly late and have only started thinking about it a few weeks ago. The regulators have not helped, causing last minute confusion over who is impacted.
Mitchell: The rule changes are a material change for many asset managers, particularly those that make widespread use of FX hedging but do not trade OTC derivatives. The effect of the regulation is to bring many more funds into scope for daily margining activities for the first time, including those that simply use passive FX hedging structures and share class hedging.
This has created documentation challenges as new credit support annex master agreements are put in place across many more funds and operational challenges to set up the margining process. A further complication arises for funds that do not naturally hold assets that can be accepted as collateral and there has been increased interest in the use of financing solutions to raise cash or eligible collateral for margining purposes.
In December, regulators such as the UK鈥檚 Financial Conduct Authority (FCA) have indicated they may not enforce the rules in a number of areas as of January, in anticipation of a reduction in scope by the European 色花堂and Markets Authority (ESMA) during 2018.
MiFID II is nearly done. Is SFTR the next big deadline to worry about or are there earlier hurdles that should be of greater concern?
Barnard: There will always be conflicting priorities within firms, however, SFTR is the most complex, and arguably the least understood, regulation of significance to impact the securities finance industry over the next 15 to 18 months. To be compliant in line with the anticipated go-live date of SFTR, 2018 needs to be the 鈥測ear of the build鈥� and for the build to start, the Q1 2018 needs to be focused on evaluating the effect of SFTR across your organisation and developing the solution design. This may become challenging as resources are held up unexpectedly in
MiFID II remediation.
Andrew Dyson: We currently expect the European Commission to formally adopt the final technical standards around the Article 4 obligations under the SFTR early next year. After a short period of further review by The European Parliament we would expect the 12-month SFTR implementation clock to start ticking towards the end of Q1. After the work associated with MiFID II the market will have to move on to SFTR almost immediately as notwithstanding much work that has already been done there is still a lot to do to ensure that we are ready in 2019. I would highlight the areas of out of scope lending principles and the allocation of non-cash collateral down to the legal entity identifiers (LEIs) level of the lending client as key areas that will require attention
next year.
Jones: SFTR is certainly front and centre as we head into 2018. Throughout 2017 Northern Trust laid down strong foundations in areas including technology and client education and we will be accelerating on these foundations now. We expect vendors to progress with their own development which will allow firms to more clearly define their approach to compliance with the regulation. As the reporting obligations under SFTR become more transparent鈥攖his regulation will become the market鈥檚 main focus.
Mitchell: SFTR represents a significant, positive move towards enhanced transparency in securities lending but it also comes with a number of practical challenges. These include how to report the information such that it can be easily consumed and to this end, the industry continues to work diligently on identifying the optimal solution for reporting. With gathering such a volume of data, regulators will carefully map out and plan how the data will be analysed and what practical outputs or actions can be determined from the data.
Beyond SFTR, there are many evolving aspects of the marketplace. From the macro-political environment changes to the UK鈥檚 decision to exit the EU and Germany鈥檚 change in the treatment of securities lending income to stakeholders looking to optimise their balance sheet and capital usage, the industry is going through a period of change with many new opportunities emerging. A key characteristic of securities lending since its inception has been its ability to adapt and this next period of evolution will only further reinforce the importance of the industry鈥檚 adaptability.
Eurex secured its first buy-side member in September, what will this mean for the CCP debate in 2018?
Jones: The CCP debate will undoubtedly continue throughout 2018 as it has for many years, and my expectation would be that other buy-side firms will engage in a more meaningful manner, although the extent to which that occurs is the key to how widespread the use of cleared SFTs becomes. From our perspective, there are two key challenges. Firstly, our underlying client base needs to be educated on the benefits of cleared SFTs鈥攁nd we have been actively discussing this with our client base. However, the lack of tangible evidence of the benefits, and the fact that beneficial owners need a relatively high level of engagement to understand and approve the CCP model for use, have thus far made it difficult to get widespread buy-in.
Secondly, I would also be concerned about the impact of SFTR, and whether service providers and beneficial owners will have the bandwidth to commit to CCP in 2018. Although I do believe we will see progress this year.
Barnard: We believe cleared balances will grow in 2018 and 2019, driven partly by bank risk-weighted assets reduction benefits, and partly as a general move for streamlining securities financing flows in advance of SFTR. There may be significant benefits for some participants by clearing both repo and securities lending at the same CCP venue, so we see competitive pressures growing between CCPs, which should drive further innovation.
Mitchell: With a number of the post-financial crisis regulations gaining traction in the industry, there is increasing practical evidence of industry participants making changes to their trading structures to ensure that they are optimal from a number of perspectives including balance sheet usage. To that end, a variety of considerations and structures are being promoted including CCPs. The CCP model for developed market activity has continued to evolve successfully and 2018 could see an increase in volumes on the platforms. Other routes to market include peer-to-peer trading platforms, as well as pledge-based collateral structures. Given the importance of balance sheet and capital management, all of these routes to market will remain a hot topic in 2018.
Dyson: Inevitably, people will see this as something of a key milestone in the development of CCPs for our market. As we consider next year and beyond we do see a greater desire by borrowers to access lending supply in an increasing number of ways. In addition to CCP the emergence of a pledge collateral model, which International 色花堂Lending Association (ISLA) is also supporting, is another manifestation of that direction of travel. As capital and economic costs continue to shape how the borrowers think about this market the CCP option will resonate more loudly in 2018 although the debate is more 鈥榳hen鈥� than 鈥榠f鈥� now.
The ECB鈥檚 APP will ends in January, what does this mean for the EU repo market?
Mitchell: Central bank asset purchases effectively provided banks with significant liquidity which in turn made them less likely to require interbank funding including repo. Hence, any reduction in asset purchases can be expected to increase the level of demand for repo.
Barnard: The reduction in the ECB鈥檚 asset purchase programme is its next step in weaning the market off central bank driven quantitive easing. The ECB programme has purchased over 鈧�2 trillion of assets since it was launched and with its reduced pace of purchasing coupled with a mid-term desire to close the programme in totality, assets that have previously been purchased by the ECB may be offered to the more traditional repo market, as such repo volumes may well increase. However, that is only half the story. Will liquidity providers be willing to enter into bilateral repo with those that used the asset purchase programme? As yet this is unknown. To alleviate these counterparty credit issues, will the use of CCPs be used as a means to manage this risk?
Many questions will be raised as quantitative easing is reduced or ultimately removed, but in short, with the central bank stepping bank and letting the traditional market mechanisms provide liquidity, this can only offer new opportunities to the
repo market.
Jones: The ECB recently announced plans to pare monthly asset purchases, from 鈧�60 billion to 鈧�30 billion, beginning in January. While this and other modifications to the programme are widely viewed as a positive development for the availability of collateral in repo markets, we should still expect the assets in most demand to continue trading with increased premium. To note, the ECB鈥檚 sovereign debt holdings are already close to 鈧�2 trillion, and with the inflationary landscape displaying no immediate signs of change, the ECB will likely hold assets for a prolonged period, while also mitigating a 鈥榯aper tantrum鈥� type sell off.
In addition, core European sovereign bonds are experiencing increased demand over regulatory-sensitive periods as banks seek to satisfy reporting requirements with sufficient cash-like holdings. Therefore, while the reduction of the asset purchase programme and the recent more sophisticated approach to lending bonds back in to the market is clearly a positive, we feel there are a number of other variables which need to be taken into consideration when determining market liquidity in repo and securities financing markets.
Mark Barnard: Many market practitioners worked hard to meet the January deadline for the go-live and we believe the deadline was met by most. The pressing concern is the unknown level of remediation that will be needed. If firms were limiting their testing to ensure that they were second Markets in Financial Instruments Directive (MiFID II) compliant from day one, the level of 鈥榗lean up鈥� may be great and with this brings two challenges.
The quantum of remediation is potentially larger than if the initially desired level of testing had taken place and the extended period of clean up will result in staff that were allocated to non-MiFID work from January 2018 being retained and subsequently creating resourcing issues for other projects such as 色花堂Financing Transactions Regulation (SFTR).
Mark Jones: I think the securities lending market was largely ready for MiFID II. At Northern Trust, we took a centralised team approach for custody, securities lending, foreign exchange, brokerage and transition management to meet our obligations
for MiFID II.
While the main challenge for the market as a whole has been the scale of the regulation as it pertains to our individual products, our team approach ensured a consistent application across the organisation. I suspect that the range of solutions adopted across the market will look very different from firm to firm as a result of differing interpretations.
Gareth Mitchell: The objective of MiFID II is to improve investor protection, make markets more efficient and increase transparency. Although MiFID II imposes additional disclosure and compliance obligations on the agency lending businesses, we do not anticipate that there will be a material impact on the day-to-day provision of services. SFTR, which is due to come into effect in Q1 2019, will complement the transparency requirements imposed by MiFID, which currently excludes securities financing transactions. (SFTs).
The Brexit negotiations are in full swing. Given what we know now, do you expect the final deal (or lack of one) to significantly influence securities lending markets, either in the EU or globally?
Mitchell: Whilst the UK鈥檚 negotiations with the EU are still ongoing and the outcome is still unknown, market participants will have assessed potential impact on market access and are developing plans to ensure business continuity. A key point will be the availability of cross-border licenses or other arrangements within Europe which will underpin securities lending activities. Citi is well positioned to provide clients with continuity of service without disruption and provide support through the UK鈥檚 withdrawal from the EU without the assumption of a transition or implementation period.
Barnard: We see the biggest impacts of Brexit on securities financing markets being driven by loss of passporting, which could change the jurisdiction of the lending desk leading to fragmentation of liquidity and higher operational costs. Central counterparty services could also be split across the single market border, fragmenting clearing processes and reducing netting benefits.
The next phase of the over-the-counter (OTC) margin rules is also set for January. What has the implementation process been like in preparation for this latest deadline?
Barnard: Large firms are well versed in initial margin and variation margining processes so implementing foreign exchange (FX) forwards in January is 鈥渏ust another asset class鈥�, not to trivialise the work involved. But smaller firms have struggled, especially if they are margining for the first time. Some small firms have left it incredibly late and have only started thinking about it a few weeks ago. The regulators have not helped, causing last minute confusion over who is impacted.
Mitchell: The rule changes are a material change for many asset managers, particularly those that make widespread use of FX hedging but do not trade OTC derivatives. The effect of the regulation is to bring many more funds into scope for daily margining activities for the first time, including those that simply use passive FX hedging structures and share class hedging.
This has created documentation challenges as new credit support annex master agreements are put in place across many more funds and operational challenges to set up the margining process. A further complication arises for funds that do not naturally hold assets that can be accepted as collateral and there has been increased interest in the use of financing solutions to raise cash or eligible collateral for margining purposes.
In December, regulators such as the UK鈥檚 Financial Conduct Authority (FCA) have indicated they may not enforce the rules in a number of areas as of January, in anticipation of a reduction in scope by the European 色花堂and Markets Authority (ESMA) during 2018.
MiFID II is nearly done. Is SFTR the next big deadline to worry about or are there earlier hurdles that should be of greater concern?
Barnard: There will always be conflicting priorities within firms, however, SFTR is the most complex, and arguably the least understood, regulation of significance to impact the securities finance industry over the next 15 to 18 months. To be compliant in line with the anticipated go-live date of SFTR, 2018 needs to be the 鈥測ear of the build鈥� and for the build to start, the Q1 2018 needs to be focused on evaluating the effect of SFTR across your organisation and developing the solution design. This may become challenging as resources are held up unexpectedly in
MiFID II remediation.
Andrew Dyson: We currently expect the European Commission to formally adopt the final technical standards around the Article 4 obligations under the SFTR early next year. After a short period of further review by The European Parliament we would expect the 12-month SFTR implementation clock to start ticking towards the end of Q1. After the work associated with MiFID II the market will have to move on to SFTR almost immediately as notwithstanding much work that has already been done there is still a lot to do to ensure that we are ready in 2019. I would highlight the areas of out of scope lending principles and the allocation of non-cash collateral down to the legal entity identifiers (LEIs) level of the lending client as key areas that will require attention
next year.
Jones: SFTR is certainly front and centre as we head into 2018. Throughout 2017 Northern Trust laid down strong foundations in areas including technology and client education and we will be accelerating on these foundations now. We expect vendors to progress with their own development which will allow firms to more clearly define their approach to compliance with the regulation. As the reporting obligations under SFTR become more transparent鈥攖his regulation will become the market鈥檚 main focus.
Mitchell: SFTR represents a significant, positive move towards enhanced transparency in securities lending but it also comes with a number of practical challenges. These include how to report the information such that it can be easily consumed and to this end, the industry continues to work diligently on identifying the optimal solution for reporting. With gathering such a volume of data, regulators will carefully map out and plan how the data will be analysed and what practical outputs or actions can be determined from the data.
Beyond SFTR, there are many evolving aspects of the marketplace. From the macro-political environment changes to the UK鈥檚 decision to exit the EU and Germany鈥檚 change in the treatment of securities lending income to stakeholders looking to optimise their balance sheet and capital usage, the industry is going through a period of change with many new opportunities emerging. A key characteristic of securities lending since its inception has been its ability to adapt and this next period of evolution will only further reinforce the importance of the industry鈥檚 adaptability.
Eurex secured its first buy-side member in September, what will this mean for the CCP debate in 2018?
Jones: The CCP debate will undoubtedly continue throughout 2018 as it has for many years, and my expectation would be that other buy-side firms will engage in a more meaningful manner, although the extent to which that occurs is the key to how widespread the use of cleared SFTs becomes. From our perspective, there are two key challenges. Firstly, our underlying client base needs to be educated on the benefits of cleared SFTs鈥攁nd we have been actively discussing this with our client base. However, the lack of tangible evidence of the benefits, and the fact that beneficial owners need a relatively high level of engagement to understand and approve the CCP model for use, have thus far made it difficult to get widespread buy-in.
Secondly, I would also be concerned about the impact of SFTR, and whether service providers and beneficial owners will have the bandwidth to commit to CCP in 2018. Although I do believe we will see progress this year.
Barnard: We believe cleared balances will grow in 2018 and 2019, driven partly by bank risk-weighted assets reduction benefits, and partly as a general move for streamlining securities financing flows in advance of SFTR. There may be significant benefits for some participants by clearing both repo and securities lending at the same CCP venue, so we see competitive pressures growing between CCPs, which should drive further innovation.
Mitchell: With a number of the post-financial crisis regulations gaining traction in the industry, there is increasing practical evidence of industry participants making changes to their trading structures to ensure that they are optimal from a number of perspectives including balance sheet usage. To that end, a variety of considerations and structures are being promoted including CCPs. The CCP model for developed market activity has continued to evolve successfully and 2018 could see an increase in volumes on the platforms. Other routes to market include peer-to-peer trading platforms, as well as pledge-based collateral structures. Given the importance of balance sheet and capital management, all of these routes to market will remain a hot topic in 2018.
Dyson: Inevitably, people will see this as something of a key milestone in the development of CCPs for our market. As we consider next year and beyond we do see a greater desire by borrowers to access lending supply in an increasing number of ways. In addition to CCP the emergence of a pledge collateral model, which International 色花堂Lending Association (ISLA) is also supporting, is another manifestation of that direction of travel. As capital and economic costs continue to shape how the borrowers think about this market the CCP option will resonate more loudly in 2018 although the debate is more 鈥榳hen鈥� than 鈥榠f鈥� now.
The ECB鈥檚 APP will ends in January, what does this mean for the EU repo market?
Mitchell: Central bank asset purchases effectively provided banks with significant liquidity which in turn made them less likely to require interbank funding including repo. Hence, any reduction in asset purchases can be expected to increase the level of demand for repo.
Barnard: The reduction in the ECB鈥檚 asset purchase programme is its next step in weaning the market off central bank driven quantitive easing. The ECB programme has purchased over 鈧�2 trillion of assets since it was launched and with its reduced pace of purchasing coupled with a mid-term desire to close the programme in totality, assets that have previously been purchased by the ECB may be offered to the more traditional repo market, as such repo volumes may well increase. However, that is only half the story. Will liquidity providers be willing to enter into bilateral repo with those that used the asset purchase programme? As yet this is unknown. To alleviate these counterparty credit issues, will the use of CCPs be used as a means to manage this risk?
Many questions will be raised as quantitative easing is reduced or ultimately removed, but in short, with the central bank stepping bank and letting the traditional market mechanisms provide liquidity, this can only offer new opportunities to the
repo market.
Jones: The ECB recently announced plans to pare monthly asset purchases, from 鈧�60 billion to 鈧�30 billion, beginning in January. While this and other modifications to the programme are widely viewed as a positive development for the availability of collateral in repo markets, we should still expect the assets in most demand to continue trading with increased premium. To note, the ECB鈥檚 sovereign debt holdings are already close to 鈧�2 trillion, and with the inflationary landscape displaying no immediate signs of change, the ECB will likely hold assets for a prolonged period, while also mitigating a 鈥榯aper tantrum鈥� type sell off.
In addition, core European sovereign bonds are experiencing increased demand over regulatory-sensitive periods as banks seek to satisfy reporting requirements with sufficient cash-like holdings. Therefore, while the reduction of the asset purchase programme and the recent more sophisticated approach to lending bonds back in to the market is clearly a positive, we feel there are a number of other variables which need to be taken into consideration when determining market liquidity in repo and securities financing markets.
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