Out with the new, in with the old
The securities lending market has been highly regulated for many years with the Bank of England (BoE) overseeing the markets by appointing the Money Brokers as the gate keepers for the lending of stock and cash in the UK. However, there has always existed an element of trust between the regulators and the markets whereby the markets have been allowed a degree of flexibility in their day-to-day activities, with the regulators trusting that they will endeavour to ‘do the right thing.’
Over the years, these old fashioned values have enabled the securities lending and repo markets to thrive. Their ability to generate trading opportunities in the changing market place and their responsiveness to arbitrage opportunities have been key to this success.
However, the very nature of securities lending means that it has a big impact on the balance sheets of firms and involves high usage of credit lines. This understandably attracted the attention of the regulators in the wake of the 2008 financial crisis. Unfortunately, both the regulators and fund managers (who are less immersed in the securities lending world) tend to view securities lending as a very risky line of business. In actual fact, the primary risk exposures of the securities lending business are covered by the collateral margins, making it a relatively ‘safe’ industry. For example, the non-cash collateral posted in the Lehman’s incident was recovered.
Regulations such as the European Market Infrastructure Regulation (EMIR), Dodd-Frank and MiFID II all have an impact on traditional securities lending business lines, making it difficult for them to maintain profitability. This is important, as the primary function of the securities lending markets is to provide liquidity to the broader industry. Any hindrance to their ability to perform this role could result in ‘gridlock’ elsewhere in the system. So, is there any hope?
The answer (thankfully) is yes. Although increased regulation will make it more difficult for securities lending desks to generate profits using traditional channels, it will also create new opportunities for collateral trading. The exact nature of these opportunities remains to be seen, but with regulatory reform driving demand for high quality liquid assets, the cost of collateral will undoubtedly increase. The ability to capitalise on this pricing increase will be a key competitive differentiator in the years to come.
Turning a profit in the securities lending world has certainly been made more difficult by the introduction of new regulations in the wake of the 2008 financial crisis. However, astute participants will have already realised that it has also created new opportunities. For an industry that is renowned for its flexibility and adaptability, capitalising on these opportunities will not be a problem. Nonetheless, this is not an ideal situation to be in.
Some have voiced concerns that the regulators may have gone too far in constraining the activities of the securities lending markets. If we are to continue to rely on them to provide liquidity to the wider markets then we need to allow them to operate in what they deem to be the most efficient and effective manner. This entails trusting them to ‘do the right thing.’
Whilst the new regulatory model arguably goes too far, the motives and intentions of the regulators are understandable. Perhaps what is truly needed here is a happy medium between the old and the new. We should reintroduce an element of the trust that has seemingly been lost in the regulatory reforms, whilst maintaining the regulatory oversight necessary to avert another financial meltdown.
This blog appeared on Finextra. Click here to see the entry on the Finextra website