Canada
27 September 2011
While staying on course, the Canadian securities lending market is trying to seize opportunities and improve the legislative landscape for the future
Image: Shutterstock
Slow聽and聽steady are the two words that聽Reeve聽Serman, head of securities lending trading and market execution at RBC Dexia, uses to describe the Canadian securities lending market.
The Bank of Canada鈥檚 prudent fiscal policies and the country鈥檚 comparatively functional聽majority聽conservative聽government has sparked聽investor confidence聽resulting聽in聽strong聽demand for the country鈥檚聽debt,聽and high levels of interest in the聽equity聽markets聽have held up 鈥渞emarkably well鈥�,聽says聽Serman.
鈥淭here is huge聽global聽demand for聽purchasing聽high quality government debt聽right now from the investment community鈥� says聽Serman, adding that this same intensifying demand is being聽聽translated into聽multiple聽opportunities聽across RBC Dexia鈥檚 global聽lending聽desks for high quality聽Canadian and聽European government debt.聽
And while a聽myriad of inconsistent and unpredictable short selling regulations across the world are adding an administrative burden to stock lending and dampening the聽demand side聽of the non-Canadian equity book, Canadian equity balances have, in contrast,聽held strong he notes.聽
The聽global聽custodian bank has four trading desks covering North America, Europe, Spain and Asia-Pacific and is active in 28 markets. The securities lending聽trading聽arm headed by聽Serman聽has a globally diversified book of business, with high concentrations in North America and Europe and a significant contribution from the Far East.
August was a particularly聽volatile聽month聽from a risk perspective聽as both the eurozone debt crisis and聽US political dysfunction in addressing its debt burdens rattled markets causing a global sell-off in equities and, simultaneously, flight-to-safety investing.
鈥淚n Canada, from a risk perspective,聽we are not overly concerned聽as聽the major聽securities lending聽participants聽are the major banks, which are some of the best banks globally with solid balance sheets. That brings an element of comfort聽from a credit risk perspective聽and allows us to trade up with high balances with less concerns聽from聽risk departments, lenders and borrowers,鈥澛燬erman聽says.
Though there has been a rebound聽since the summer, there are still significant market jitters and all eyes have turned to eurozone developments in Greece聽and to a lesser extent聽in聽Spain聽and Italy, while increasing concerns around French Banks鈥� exposure to these countries is mounting.
鈥淭he eurozone does not seem to have an aligned vision, there are divergent views on how to fix [the sovereign debt crisis] and no real consensus. Italy seems to have a vision of raising taxes, and France is facing an election next year, the expectation on Germany to carry the eurozone is not sustainable and everyone is looking to the US for an economic rebound, there is an election there next year...I think聽ugly聽politics are a major聽hurdle in聽resolving聽this global economic downturn,鈥� says聽Serman.
Moreover, the US鈥� persistent high unemployment rate, high debt levels, low rates of聽consumption, among other macroeconomic and internal political dynamics are causing concerns over the potential impact on Canada if the situation continues. Still, the country鈥檚 economy is proving to be highly resilient.
In terms of global securities lending, Canada is RBC Dexia鈥檚 home market and where it has depth and strength,聽and while it remains a major focus,聽in聽terms of growth,聽Serman聽says higher incremental returns are expected from its European聽desk. 聽鈥淲e are seeing聽opportunity in the eurozone specific to securities lending聽as we聽bring聽more supply into our programme as a result of [the joint venture between RBC and Dexia]. Dexia has聽lots of clients and has successfully brought in new participants,鈥澛燬erman聽adds.
At the same time, risk management functions are taking up more and more of his time. There is a lot of focus on reducing concentration risk on both the loan and collateral side, focusing on liquidity risk for both聽loans聽and聽collateral as well as聽looking at the correlation risk between the collateral and lending portfolios. For equity loans verse equity collateral, explains Serman, the correlation risk of a portfolio is significantly reduced 鈥� if the market moves聽sharply聽in either direction, both the loan portfolio and collateral portfolio drop or rise in a more correlated聽manner.聽
The same is not true聽for an聽equity loan portfolio versus a fixed income collateral portfolio, where one would observe a higher correlation risk between the portfolios聽as聽markets move.
鈥淩isk is not聽something to be afraid of. One needs to understand it and be able to partner with one鈥檚 risk group and clients聽to strategically manage it,鈥澛燬erman聽says.
鈥淲e would like to see more clients understand how [using equities as collateral] can help them reduce their risk聽profile聽in the market. Historically, everyone thought聽the best kind of collateral is government debt but if聽one factors in聽correlation risk聽during periods of high聽volatility...equities on equities clearly reduces risk. Many聽models聽and聽research papers published by credible sources聽demonstrate聽this聽dynamic,鈥� Serman says. 聽聽
Through聽CASLA,聽the聽Canadian聽Securities Lending Association,聽an industry representative body where聽he聽is a member of the board, Serman would like聽to engage industry participants, including聽 Canadian regulators, in meaningful discussions to increase awareness and benefits of collateral alternatives, including equities, from a risk reward perspective.聽In addition, borrowers are receptive to paying higher margin levels for equity collateral聽at a time when restrictions are many and聽collateral聽costs are high for聽good quality government debt聽collateral.聽聽聽
鈥淚 am finding a new dynamic in the securities lending world,聽where聽there is a disjoint between the demand and supply side of the market,鈥� says聽Serman. 鈥淏orrowers want lenders to be more flexible on not just collateral, but also term structures,聽which provide聽certain financial institutions聽balance sheet聽advantages聽as a result of聽certain聽term structures聽specific to high quality government debt. If lenders were open to [this], there is a huge opportunity which is not really being capitalised聽on as lenders聽struggle聽to聽get聽these opportunities聽approved internally,鈥� he adds.聽 鈥淲hile securities lending may聽not be a core product of聽lenders, these opportunities can result in聽significant incremental revenue streams聽in a risk adjusted manner.鈥澛犅�
It might be too much to ask for flexibility at a time when playing it safe is on most agendas. One area that聽Serman聽has seen a significant shift towards this attitude is in the specials market. Although the slowing of this activity is indicative of less mergers and acquisitions activity, it is also a reflection of a diversified risk adjusted return聽approach, meaning less capital being allocated to聽highly concentrated one-off聽trading聽opportunities聽as聽caution聽is being聽applied聽to decisions on how to best allocate that capital.
But just as lenders are cautious in flexibility and big risks, they are not shying away from new 鈥渞ules of engagement鈥� in terms of demanding transparency, benchmarking,聽reporting聽and analytics.
鈥淚t is a bitter sweet dynamic, we are encouraged that [lenders] are getting more sophisticated, however, with that comes a lot of extra management with the clients,鈥澛燬erman聽notes.
For now, participants in the Canadian securities lending market are focused on operational efficiency, risk management automation and managing the underlying client. While an initiative to start a CCP聽for聽Canada, though getting some attention in the聽market, is not a priority for the immediate聽future, he adds.
Paving the way
Still, CCPs are an expected requirement for certain transactions under the US Dodd-Frank Act and participants in Canada are moving in this direction, as are many other markets. In general, CCPs offer benefits around efficiency, transparency and risk-reduction, but CCPs only make sense if they can achieve these goals without unduly driving up costs, says Rob Ferguson, head of global securities lending at CIBC Mellon.
鈥淐onceptually, CCPs are an interesting idea and certainly worth discussing 鈥� so long as benefits outweigh costs. To date, however, it has been difficult to identify the benefits for our underlying securities lending and borrowing clients,鈥� he says.
That is, in part, because borrowers and lenders can create a bespoke model and make choices on collateral, counterparties and design a risk profile. Ferguson notes that CCP models could take away some of that flexibility, while also not making it clear who the counterparties are.
鈥淚 am not saying that a CCP model is more risky, it just might not result in the particular risk profile that clients would have chosen under a non-CCP model,鈥� he says. 鈥淸CCPs] could take away the clients鈥� ability to control the composition of their risk balance.鈥�
He also thinks that a CCP for Canada鈥檚 securities lending market is far from being a done deal.
鈥淚 am not sure that we could just be an island. If other jurisdictions move to CCP models and become comfortable with their operation, I could see participants becoming more comfortable with the various risk profile, cost and revenue implications of a CCP model. So if the rest of world moves in this direction, maybe we would see it happen here in Canada, but I certainly don鈥檛 see this as a slam dunk,鈥� he notes.
This is particularly true as any increased costs are anathema in an environment of global economic challenges. Though 2011 has been stronger than 2010 for CIBC Mellon鈥檚 securities lending business, uncertainty and negativity as a result of macroeconomic concerns may impact business volumes, says Ferguson, adding that low interest rates and a flat yield curve are also making cash reinvestment more challenging.
One of the areas gaining traction is the use of equity collateral in the post-credit crisis landscape. Though non-cash collateral tends to be predominantly government sovereign debt 鈥� accounting for some 90 per cent 鈥� participants are showing increased interest in broadening what is acceptable as collateral in securities lending transactions.
More than three-quarters of Canadian agent lending is done versus non-cash collateral - that has dropped off somewhat from just over a decade ago, when the figure was above 90 per cent. At the same time, barriers to using non-cash collateral are relatively small if a security is deemed qualified under Canada鈥檚 Income Tax Act, Ferguson says.
Mutual funds, a relatively new player in Canadian securities lending, are prohibited from accepting equity collateral.
鈥淭hese rules do disadvantage mutual funds, putting them on unequal footing with pension funds, for example,鈥� Ferguson says.
He is supportive of the efforts to broaden collateral being undertaken by CASLA and its president Rob Chiuch.
鈥淎 smaller part of broadening collateral is about improving a client鈥檚 risk profile. We would never tell a client to take 100 per cent equity collateral, but we would say a small percentage of equities would improve your risk profile. If regulations were amended to broaden collateral acceptability, mutual funds might then be able to accept equity collateral, which in turn could mean new revenue opportunities,鈥� Ferguson says.
But in the here and now in the securities lending industry, despite challenges, the uncertainty cloud hanging over markets does have a silver lining; uncertainty often lends itself to some securities lending optimism.
Ferguson points to solar energy company stocks as an example, where a combination of short-term downward price pressure, but good longer term prospects is creating revenue opportunities for both borrowers and lenders.
鈥淔rom CIBC Mellon鈥檚 perspective, our lending program continues to grow as we add new clients and earn additional business from our existing partners. I remain cautiously optimistic about the market in 2012,鈥� says Ferguson.
Simply tax
From a tax perspective, Canada is mired in layers of draft legislation as part of the Income Tax Act, impacting the efficiency of the market, says Reya Ali-Dabydeen, tax partner in the Financial Services Group at Ernst & Young.
鈥淲e need to have more clarity. Today, we rely on the draft legislation to perform transactions on the assumption that the Department of 麻豆影视传媒 would provide us certainty,鈥� Ali-Dabydeen says.
Currently, analysis of trade requires that tax聽advisers聽look at draft legislation from 2002聽and 2006, which often shows a variance between the two, making the process inefficient, he adds.
But withholding taxes are the biggest issue for Ernst & Young clients, he notes, as Canadians borrowing, for example, European equities are charged withholding tax on聽the聽compensation payments.
鈥淐anada needs to start thinking about how it applies withholding taxes on non-Canadian source dividends鈥t the moment the process is market inefficient,鈥� Ali-Dabydeen says.
Clients are using derivatives instruments to deal with this inefficiency in order to synthesise聽desired returns, but this is also an area without a clear set of rules.
鈥淐anadian rules lack a cohesive scheme, different bits and pieces of [the Income Tax Act] need to be tied together. This is not a bad thing as some of those rules are intended to prevent tax avoidance but where other jurisdictions have comprehensive securities lending rules, Canada does not. [The government] should at the very least be passing current legislation but at the same time begin thinking about rules in a comprehensive fashion,鈥� he says. 鈥淩ight now, there are always bigger聽legislative聽issues and the size of Canada鈥檚 market may not attract聽麻豆影视传媒鈥檚 attention,聽and so it is one of those areas that is not a priority of the Department of 麻豆影视传媒 as one might hope.鈥�
In general, Ali-Dabydeen positions Canada somewhere between the US and UK in terms of development. Canada could do more to follow the example set by the City of London, which lobbies aggressively for clear guidance on capital markets, but without going as far as the US in terms of the complexity of burdensome rules.
鈥淭he risk [of not having a clear framework] is that transactions are more expensive partly because聽of the lack of clarity, but also it may impede the development of the Canadian securities lending market,鈥� he says. SLT
The Bank of Canada鈥檚 prudent fiscal policies and the country鈥檚 comparatively functional聽majority聽conservative聽government has sparked聽investor confidence聽resulting聽in聽strong聽demand for the country鈥檚聽debt,聽and high levels of interest in the聽equity聽markets聽have held up 鈥渞emarkably well鈥�,聽says聽Serman.
鈥淭here is huge聽global聽demand for聽purchasing聽high quality government debt聽right now from the investment community鈥� says聽Serman, adding that this same intensifying demand is being聽聽translated into聽multiple聽opportunities聽across RBC Dexia鈥檚 global聽lending聽desks for high quality聽Canadian and聽European government debt.聽
And while a聽myriad of inconsistent and unpredictable short selling regulations across the world are adding an administrative burden to stock lending and dampening the聽demand side聽of the non-Canadian equity book, Canadian equity balances have, in contrast,聽held strong he notes.聽
The聽global聽custodian bank has four trading desks covering North America, Europe, Spain and Asia-Pacific and is active in 28 markets. The securities lending聽trading聽arm headed by聽Serman聽has a globally diversified book of business, with high concentrations in North America and Europe and a significant contribution from the Far East.
August was a particularly聽volatile聽month聽from a risk perspective聽as both the eurozone debt crisis and聽US political dysfunction in addressing its debt burdens rattled markets causing a global sell-off in equities and, simultaneously, flight-to-safety investing.
鈥淚n Canada, from a risk perspective,聽we are not overly concerned聽as聽the major聽securities lending聽participants聽are the major banks, which are some of the best banks globally with solid balance sheets. That brings an element of comfort聽from a credit risk perspective聽and allows us to trade up with high balances with less concerns聽from聽risk departments, lenders and borrowers,鈥澛燬erman聽says.
Though there has been a rebound聽since the summer, there are still significant market jitters and all eyes have turned to eurozone developments in Greece聽and to a lesser extent聽in聽Spain聽and Italy, while increasing concerns around French Banks鈥� exposure to these countries is mounting.
鈥淭he eurozone does not seem to have an aligned vision, there are divergent views on how to fix [the sovereign debt crisis] and no real consensus. Italy seems to have a vision of raising taxes, and France is facing an election next year, the expectation on Germany to carry the eurozone is not sustainable and everyone is looking to the US for an economic rebound, there is an election there next year...I think聽ugly聽politics are a major聽hurdle in聽resolving聽this global economic downturn,鈥� says聽Serman.
Moreover, the US鈥� persistent high unemployment rate, high debt levels, low rates of聽consumption, among other macroeconomic and internal political dynamics are causing concerns over the potential impact on Canada if the situation continues. Still, the country鈥檚 economy is proving to be highly resilient.
In terms of global securities lending, Canada is RBC Dexia鈥檚 home market and where it has depth and strength,聽and while it remains a major focus,聽in聽terms of growth,聽Serman聽says higher incremental returns are expected from its European聽desk. 聽鈥淲e are seeing聽opportunity in the eurozone specific to securities lending聽as we聽bring聽more supply into our programme as a result of [the joint venture between RBC and Dexia]. Dexia has聽lots of clients and has successfully brought in new participants,鈥澛燬erman聽adds.
At the same time, risk management functions are taking up more and more of his time. There is a lot of focus on reducing concentration risk on both the loan and collateral side, focusing on liquidity risk for both聽loans聽and聽collateral as well as聽looking at the correlation risk between the collateral and lending portfolios. For equity loans verse equity collateral, explains Serman, the correlation risk of a portfolio is significantly reduced 鈥� if the market moves聽sharply聽in either direction, both the loan portfolio and collateral portfolio drop or rise in a more correlated聽manner.聽
The same is not true聽for an聽equity loan portfolio versus a fixed income collateral portfolio, where one would observe a higher correlation risk between the portfolios聽as聽markets move.
鈥淩isk is not聽something to be afraid of. One needs to understand it and be able to partner with one鈥檚 risk group and clients聽to strategically manage it,鈥澛燬erman聽says.
鈥淲e would like to see more clients understand how [using equities as collateral] can help them reduce their risk聽profile聽in the market. Historically, everyone thought聽the best kind of collateral is government debt but if聽one factors in聽correlation risk聽during periods of high聽volatility...equities on equities clearly reduces risk. Many聽models聽and聽research papers published by credible sources聽demonstrate聽this聽dynamic,鈥� Serman says. 聽聽
Through聽CASLA,聽the聽Canadian聽Securities Lending Association,聽an industry representative body where聽he聽is a member of the board, Serman would like聽to engage industry participants, including聽 Canadian regulators, in meaningful discussions to increase awareness and benefits of collateral alternatives, including equities, from a risk reward perspective.聽In addition, borrowers are receptive to paying higher margin levels for equity collateral聽at a time when restrictions are many and聽collateral聽costs are high for聽good quality government debt聽collateral.聽聽聽
鈥淚 am finding a new dynamic in the securities lending world,聽where聽there is a disjoint between the demand and supply side of the market,鈥� says聽Serman. 鈥淏orrowers want lenders to be more flexible on not just collateral, but also term structures,聽which provide聽certain financial institutions聽balance sheet聽advantages聽as a result of聽certain聽term structures聽specific to high quality government debt. If lenders were open to [this], there is a huge opportunity which is not really being capitalised聽on as lenders聽struggle聽to聽get聽these opportunities聽approved internally,鈥� he adds.聽 鈥淲hile securities lending may聽not be a core product of聽lenders, these opportunities can result in聽significant incremental revenue streams聽in a risk adjusted manner.鈥澛犅�
It might be too much to ask for flexibility at a time when playing it safe is on most agendas. One area that聽Serman聽has seen a significant shift towards this attitude is in the specials market. Although the slowing of this activity is indicative of less mergers and acquisitions activity, it is also a reflection of a diversified risk adjusted return聽approach, meaning less capital being allocated to聽highly concentrated one-off聽trading聽opportunities聽as聽caution聽is being聽applied聽to decisions on how to best allocate that capital.
But just as lenders are cautious in flexibility and big risks, they are not shying away from new 鈥渞ules of engagement鈥� in terms of demanding transparency, benchmarking,聽reporting聽and analytics.
鈥淚t is a bitter sweet dynamic, we are encouraged that [lenders] are getting more sophisticated, however, with that comes a lot of extra management with the clients,鈥澛燬erman聽notes.
For now, participants in the Canadian securities lending market are focused on operational efficiency, risk management automation and managing the underlying client. While an initiative to start a CCP聽for聽Canada, though getting some attention in the聽market, is not a priority for the immediate聽future, he adds.
Paving the way
Still, CCPs are an expected requirement for certain transactions under the US Dodd-Frank Act and participants in Canada are moving in this direction, as are many other markets. In general, CCPs offer benefits around efficiency, transparency and risk-reduction, but CCPs only make sense if they can achieve these goals without unduly driving up costs, says Rob Ferguson, head of global securities lending at CIBC Mellon.
鈥淐onceptually, CCPs are an interesting idea and certainly worth discussing 鈥� so long as benefits outweigh costs. To date, however, it has been difficult to identify the benefits for our underlying securities lending and borrowing clients,鈥� he says.
That is, in part, because borrowers and lenders can create a bespoke model and make choices on collateral, counterparties and design a risk profile. Ferguson notes that CCP models could take away some of that flexibility, while also not making it clear who the counterparties are.
鈥淚 am not saying that a CCP model is more risky, it just might not result in the particular risk profile that clients would have chosen under a non-CCP model,鈥� he says. 鈥淸CCPs] could take away the clients鈥� ability to control the composition of their risk balance.鈥�
He also thinks that a CCP for Canada鈥檚 securities lending market is far from being a done deal.
鈥淚 am not sure that we could just be an island. If other jurisdictions move to CCP models and become comfortable with their operation, I could see participants becoming more comfortable with the various risk profile, cost and revenue implications of a CCP model. So if the rest of world moves in this direction, maybe we would see it happen here in Canada, but I certainly don鈥檛 see this as a slam dunk,鈥� he notes.
This is particularly true as any increased costs are anathema in an environment of global economic challenges. Though 2011 has been stronger than 2010 for CIBC Mellon鈥檚 securities lending business, uncertainty and negativity as a result of macroeconomic concerns may impact business volumes, says Ferguson, adding that low interest rates and a flat yield curve are also making cash reinvestment more challenging.
One of the areas gaining traction is the use of equity collateral in the post-credit crisis landscape. Though non-cash collateral tends to be predominantly government sovereign debt 鈥� accounting for some 90 per cent 鈥� participants are showing increased interest in broadening what is acceptable as collateral in securities lending transactions.
More than three-quarters of Canadian agent lending is done versus non-cash collateral - that has dropped off somewhat from just over a decade ago, when the figure was above 90 per cent. At the same time, barriers to using non-cash collateral are relatively small if a security is deemed qualified under Canada鈥檚 Income Tax Act, Ferguson says.
Mutual funds, a relatively new player in Canadian securities lending, are prohibited from accepting equity collateral.
鈥淭hese rules do disadvantage mutual funds, putting them on unequal footing with pension funds, for example,鈥� Ferguson says.
He is supportive of the efforts to broaden collateral being undertaken by CASLA and its president Rob Chiuch.
鈥淎 smaller part of broadening collateral is about improving a client鈥檚 risk profile. We would never tell a client to take 100 per cent equity collateral, but we would say a small percentage of equities would improve your risk profile. If regulations were amended to broaden collateral acceptability, mutual funds might then be able to accept equity collateral, which in turn could mean new revenue opportunities,鈥� Ferguson says.
But in the here and now in the securities lending industry, despite challenges, the uncertainty cloud hanging over markets does have a silver lining; uncertainty often lends itself to some securities lending optimism.
Ferguson points to solar energy company stocks as an example, where a combination of short-term downward price pressure, but good longer term prospects is creating revenue opportunities for both borrowers and lenders.
鈥淔rom CIBC Mellon鈥檚 perspective, our lending program continues to grow as we add new clients and earn additional business from our existing partners. I remain cautiously optimistic about the market in 2012,鈥� says Ferguson.
Simply tax
From a tax perspective, Canada is mired in layers of draft legislation as part of the Income Tax Act, impacting the efficiency of the market, says Reya Ali-Dabydeen, tax partner in the Financial Services Group at Ernst & Young.
鈥淲e need to have more clarity. Today, we rely on the draft legislation to perform transactions on the assumption that the Department of 麻豆影视传媒 would provide us certainty,鈥� Ali-Dabydeen says.
Currently, analysis of trade requires that tax聽advisers聽look at draft legislation from 2002聽and 2006, which often shows a variance between the two, making the process inefficient, he adds.
But withholding taxes are the biggest issue for Ernst & Young clients, he notes, as Canadians borrowing, for example, European equities are charged withholding tax on聽the聽compensation payments.
鈥淐anada needs to start thinking about how it applies withholding taxes on non-Canadian source dividends鈥t the moment the process is market inefficient,鈥� Ali-Dabydeen says.
Clients are using derivatives instruments to deal with this inefficiency in order to synthesise聽desired returns, but this is also an area without a clear set of rules.
鈥淐anadian rules lack a cohesive scheme, different bits and pieces of [the Income Tax Act] need to be tied together. This is not a bad thing as some of those rules are intended to prevent tax avoidance but where other jurisdictions have comprehensive securities lending rules, Canada does not. [The government] should at the very least be passing current legislation but at the same time begin thinking about rules in a comprehensive fashion,鈥� he says. 鈥淩ight now, there are always bigger聽legislative聽issues and the size of Canada鈥檚 market may not attract聽麻豆影视传媒鈥檚 attention,聽and so it is one of those areas that is not a priority of the Department of 麻豆影视传媒 as one might hope.鈥�
In general, Ali-Dabydeen positions Canada somewhere between the US and UK in terms of development. Canada could do more to follow the example set by the City of London, which lobbies aggressively for clear guidance on capital markets, but without going as far as the US in terms of the complexity of burdensome rules.
鈥淭he risk [of not having a clear framework] is that transactions are more expensive partly because聽of the lack of clarity, but also it may impede the development of the Canadian securities lending market,鈥� he says. SLT
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