The International Securities Lending Association (“ISLA”) released a report finding that there is “clear interconnectivity” between regulation and securities lending market behavior.” The report identifies trends in the market that are backed by detailed data collection. Trends highlighted in the report include: “UCITS funds appear to be less able to engage in lending due to regulation, corporate bonds appear to be less attractive as a collateral security due to higher bank balance sheet charges, and the demand to borrow High Quality Liquidity Assets (HQLA) continues to grow as a result of Basel III, EMIR and similar regimes that require the mobilisation of collateral. Specifically, the report noted the following:
- on-loan balances increased 8.5% globally from €1.7 trillion to €1.8 trillion from the preceding 6 months;
- mutual funds and pension plans continue to dominate the global lending pool;
- government bonds account for 39% of all securities on-loan;
- equity loan balances grew 13%, representing the largest proportion of outstanding loans;
- the movement towards the use of non-cash collateral continued; and
- equities represented 57% of the collateral pool held by tri-party service provider.
Lofchie Comment: There is an inherent limitation in ISLA’s report in that the statistics provided do not include data from the “repo” market. Since securities lending and repo are in many respects fungible transactions, it would be useful to know whether market counterparties are replacing one form of transaction with the other, or whether similar trends are appearing in both types of transactions.
Two observations from the report may resonate: first, the form of transactions in the securities lending markets is being driven by regulations. One has the sense that the regulators driving these rules do not feel comfortable dealing with securities lending, and appear to be mistakenly inclined to regulate the transactions in a manner similar to unsecured loans; i.e., as commercial banking transactions. Clearly, this faulty analogy is problematic. Second, the fact that various regulations strongly favor the use of government securities as collateral, (e.g., the regulations relating to derivatives as well as regulations regarding liquidity,) should logically result in market participants over-valuing holding government debt versus holding private corporate debt. This would generally seem to be a negative for the markets, particularly as it is obviously not the case that all government debt is free of credit risk, let alone market risk.