Dan Copin, Group Head for Securities Finance and Repo at CACEIS explains the factors shaping securities financing this year, and providing clients with clear insight on what to expect from the industry going forward.
The impacts of and adaptations to the current Covid-19 health crisis
Whereas the 2008 crisis was financial in nature and provided various pointers as to its forthcoming arrival, the current crisis was sparked off by a non-financial event that was all but impossible to predict. This crisis has had a significant impact on the small and medium enterprises comprising the real economy, but a major impact on trading activities as well.
As initial reports of a lockdown in Italy hit the news at the end of February, European economies started to tremble but at the same time, with other countries following Italy’s steps, some opportunities on the market arose. Indeed, for the securities finance desk, this period provided excellent opportunities for business. The financing activities performed well as demand increased, driven by institutional clients’ fears that an indefinite lockdown might hamper their treasury capacities over time and lead to a liquidity crisis. The timing played a big part as the crisis started around the end of March when quarterly statements were due. This is a key period regarding liquidity management as companies needs to honour payments obligations and seek to deliver a robust financial snapshot. Demand for borrowing collateral also rose, and so became increasingly expensive, even for very GC liquid securities. The main reason was the need to collateralise the many derivative products which experienced a drop in market valuation of sometimes more than 30% at the peak of the crisis.
Although many clients were very concerned by the situation, there was no accompanying panic and most of them stuck to their lending programmes throughout the crisis period. This level-headed reaction helped avoid a liquidity crisis in the market by making securities available. Central banks were also very active during March and April, providing a rapid, coordinated and wide-ranging response to the events. The economic strategies they employed efficiently absorbed the financial shock and spreads quickly returned to normal levels.
The speedy recovery to normality on the markets nevertheless saw opportunities in special situations, such as M&A, disappear due to companies’ continued uncertainty and the excess liquidity in the market. The measures taken by central banks were necessary to avoid a liquidity crisis but markets have now lost momentum and become rather static.
During the turbulent period, communication with the clients had been a key to reassure them. Many clients were concerned that they may have to perform large-scale sell-offs of positions, and with flashbacks to 2008, not have securities on loan returned to them. The demand for daily monitoring and reports by the executive committees saw a sharp uptick.
Industry players were quick to adapt their working methods to the crisis, implementing an agile strategy with teams spread across various sites. The complex infrastructure of dealing rooms was rapidly delocalised, leveraging technology and networks to permit smart working, even for traders. Fortunately, today’s technology permits such an operation, as this would have been much more difficult in 2008. Whether remote working continues remains to be seen, as it doesn’t seem to be part of the trading room mentality. Nevertheless, the exceptional situation showed it’s possible and that our business continuity plans are solid.
A good year for financing activities, a challenging one for securities lending
The static nature of markets will continue with low levels of special situations activity due to most operations being on standby. The excess of liquidity in the market driven by central banks’ quantitative easing strategies is also likely to continue for the rest of the year. Fixed income levels are very low, with risk premiums all but disappearing.
Banks themselves are currently very well funded, with reduced balance sheets and have little need to improve reserves by borrowing HQLA securities. This is actually good news for the real economy as it has avoided a crash so far but a recovery in the future remains uncertain, being heavily dependent on market and consumer confidence. Central banks have never done so much but now it seems there is not much left they can do.
Securities lending revenues for this year are unlikely to be good but financing revenues, on the other hand, bolstered by the high demand during the initial stages of the lockdown, should compensate. Clients, realising they had decent access to financing, performed large operations in March, April and May but since June, this demand has tailed off. Players with both securities lending and financing activities should see revenues balance out but for those focused purely on securities lending, the picture is unlikely to be rosy.
The future of the business depends on how things play out over the rest of the year, such as a new lockdown and the decisions on whether to extend measures to prop up businesses and help them avoid bankruptcy. While such government support measures are in place, companies won’t need financing solutions. Governments’ support measures, combined with central bank strategies, are planned to remain in place until market and consumer confidence returns but such measures cannot continue indefinitely. If the health crisis continues, measures will have to end at some point, with a strong negative impact for companies. This winter could prove to be a difficult period and everyone’s hopes are pinned to the successful development and global roll out of a vaccine.
2021, a year to improve and adapt in a very uncertain environment
Making predictions for 2021 is hard because so much has changed. The good news is that it should at least be better than 2020. But much will depend on what happens over the coming months as the general trend points towards a gradual return to normal. Covid-19 testing programmes, although costly, are effective and so a second ‘hard’ lockdown seems less likely.
Most economists agree that if we are unable to make a return to normal quickly, many companies will not make it despite all the help governments and international institutions are providing. In this case, demand for securities will probably further decrease as supply rises because an increasing number of clients will join securities lending programmes in the search for additional performance.
Hopefully, with the help of the Central Banks and the action of the governments, the recovery will be quicker than initially expected and we will soon see the return of some M&A driven by the necessity for the companies to consolidate after a rough period for the business. This consolidation movement will be good news for the securities lending programs as it will lead to Special Situations opportunities.
Fixed income spreads will probably remain thin as they’re so closely linked to central banks and HQLAs, so we will probably see spreads continue to reduce next year.
As for the impact of regulations, SFTR was implemented this year and will soon be behind us. CSDR, with its heavy burden, has been pushed back until 2022 so we have somewhat of a regulatory hiatus in 2021. Companies should take advantage of this period where they do not have to allocate resources for regulatory topics to rationalise processes and reduce costs in order to improve margins at a time when increasing revenues is hard.
But, we are quite confident that, as always, our OTC industry will find a way out of these challenging times by continually innovating, using financial ingenuity to uncover new sources of revenue growth just like in the post-2008 period, where we saw the rise of the financing business.
The constant search for revenue will be accompanied by a broadening of the risk approach by both the providers and their clients. Taking on more risk is going to be essential if you’re looking for additional yield but players will accept risk only if it can be perfectly controlled by risk departments. That is why resources must be allocated to improve and develop risk management tools where necessary.
Finally, a key aspect of our business has always been and will remain maintaining a close dialogue with clients to understand their needs, design appropriate products and deliver tailor-made solutions. Although trading is becoming ever more automated, the human element remains essential to the relationship side of the business, working together to find solutions for the future.