Copying and distributing are prohibited without permission of the publisher
CIBC Mellon: What sets Canada apart?
15 October 2012
Canada is attracting interest from international securities lending players, says Phil Zywot, Head of Trading, CIBC Mellon
Once discounted for its conservative practices and comparatively small market, Canada continues to receive outsized attention from investors around the world for its strong governance, stable banks and effective regulation. Investors are looking to Canada for best practices and opportunities – and the country’s securities lending market players are working to respond to this growing demand.
A stable market with strong fundamentals
Canada’s resource-driven economy and dollar continue to draw strength from commodity prices, which have surged over the past ten years thanks to increasing demand from emerging economies like China and India. Canadians can also thank effective regulations and conservative mortgage lending practices for sparing the country from a sub-prime mortgage downturn similar to the one that affected our American neighbours. Canada also benefits from relatively stable (and generally civil) politics.
Even the recent victory by a separatist government in Quebec is tempered by a minority government result, with federalist parties making up a majority opposition that will likely prevent any realistic pursuit of separatism in the near term.
One of the world’s strongest financial services sectors
Canada’s financial services sector is highly consolidated among a handful of banks – all of which rank among the world’s safest. Securities lending is similar, with just four agent lenders representing approximately 90% of the market, and the borrower side dominated by six big bank-owned broker-dealers.
While in the past the Canadian broker-dealer community – and indeed the Canadian financial sector in general – was content to focus on the domestic market and largely forgo global competition, the story has been changing in recent years. Canadian financial institutions continue to weather the global economic slowdown better than many peers around the world.
Canadian regulators have long required capital and liquidity positions well in excess of international norms such as Basel III. Couple this with the strength of the Canadian dollar and a number of firms in other parts of the world looking to shore up their balance sheets through divestitures, and we are seeing Canadian banks making more international acquisitions and growing into new markets.
Global market players have been likewise heeding the good news coming out of Canada – and showing a greater appetite for Canadian government bonds as they diversify out of US treasuries – which has led to new counterparty opportunities for Canadian securities lending firms: global broker-dealers, hedge funds and beneficial owners that once dismissed Canada are now approaching Canadian firms to start or expand their market participation.
The Canadian securities lending market did not escape the global downturn in 2008 unscathed, of course, and the ongoing global slowdown has meant reduced capital markets activity around the world. Canada has nonetheless rebounded more quickly than most, and balances have again returned to the highs of 2007-2008. Canadians are conservative in general, which is demonstrated in our market’s measured approach to trading policies, collateral choices and traditional focus on the domestic market – all of which has been and continues to be a source of strength for Canada versus other markets.
Participants are working harder than ever to find the right risk balance
With the recent financial crisis of 2008 and now ongoing concerns around the eurozone, many funds, beneficial owners and market participants are reviewing their potential risk exposures. Securities lending continues to be a strong source of risk-adjusted returns for beneficial owners, and these days participants are paying particularly close attention to their risk balances in terms of both euro exposure and counterparty risk.
This focus is driving demand for agent lenders to provide expanded risk-related reporting to support beneficial owners in making lending choices that are right for them. Beneficial owners are also paying closer attention to counterparties and looking for additional customisation in their programmes.
The Canadian market is distinct from a collateral management perspective; it has traditionally been a non-cash sovereign debt collateral market, versus the US market, which is generally cash collateral, and Europe, with its mixed markets of cash, equity and sovereign. In recent years, Canadian participants have been diversifying, and the lending collateral profile today is probably closer to 80% non-cash and 20% cash collateral. The main forms of fixed income collateral are highly-rated Canadian federal and provincial government debt. Equities have also been gaining momentum lately as counterparties look toward lower-cost collateral.
As in many other markets, trading strategies and their profitability are increasingly driven by collateral management. Lenders and owners in Canada face the same choices as their counterparts around the world in terms of finding the right risk balance in terms of collateral flexibility. Broadening acceptability comes with both opportunities to increase market share and revenue, but with the trade off against the flexibility and protection that comes from narrowing collateral acceptability to only the highest-rated instruments.
This was particularly notable to participants, given the role of strong collateral profiles in helping protect beneficial owners in the Canadian market from counterparty default losses, during the depths of the 2008 crisis. Other players are exploring outsourcing collateral management as a means to mitigate counterparty risk. All in all, though Canada’s collateral market continues to move in response to changing needs, it retains a rather different character than the markets of the US or Europe.
Canada is rightly hailed around the world for the very effective performance of its regulators, but the regulatory environment remains extremely complex; there are 13 separate jurisdictions, as well as several national industry and regulatory bodies. Like many other jurisdictions around the world, the Canadian regulatory environment is also evolving as a result of both international and domestic factors. Global and cross-border regulations such as Dodd-Frank, Basel III, Facta will place new requirements on market players – a particular area of focus since many of the impacts have yet to be determined.
There are also changes on the domestic front; for example, the Investment Industry Regulatory Organization of Canada (IIROC) recently loosened the regulations around short selling, repealing the so-called ‘tick test’ requirement that a short sale not be made at a price which is less than the last sale price of the security, while also imposing pre-borrow requirements for short sales in certain circumstances.
Removing short-selling restrictions makes sense, particularly given the body of academic research – like the recently released study from the New York Federal Reserve – showing not only that short selling does not drive prices below fundamental levels, but also that it brings down liquidity costs and even enables financial incentives for researching and exposing fraudulent practices among publicly-traded companies.
Casla working with regulators and participants to build best practices
The Canadian market is characterised by effective regulators with a good working relationship with members of the industry, so the Canadian Securities Lending Association (Casla) – founded in 2009 by the four major agent lenders in Canada, and now comprising 15 members and six associate members – has been a welcome addition to the market. Casla gives stakeholders in Canada’s securities lending markets an opportunity to provide shared comment on matters of mutual interest, and gives regulators a central forum through which to pose questions to explore the impacts of potential and pending regulation.
Strength built on prudence positions
Canada well for the future In summary, it is the very factors that led many international players to overlook Canada – conservative practices, a heavy focus on risk mitigation, strong regulations and a stable market – that are drawing the world to Canada today. Stable does not mean unchanging, and the market players and stakeholders are continuing to move forward.
Canadian players in the securities lending market are embracing more advanced technology solutions – such as autoborrow features – and are working to refine their risk balances in today’s market environment. We on the agent lender side have embraced the influx of attention from new partners, and from current players on both the borrower and owner fronts looking to expand, customise and refine their lending programmes.