What effect is current monetary policy having on securities finance markets around the globe?

As we approach the end of the third quarter it will be very interesting to follow the impact of monetary policy around the world. This is not the first time we have witnessed divergence in monetary policy between nations. Historically there have been differences between European rates – notably those set by the ECB for the eurozone but also those in the UK – and those in North America. But what complicates the picture today is the high rate of quantitative easing (QE). Globally, QE is now running at $200bn per month, a higher rate than at any previous time. This is creating significant distortions in the markets in which it is being applied.

The $23bn 10-year Treasury auction in the US on 10 August was heavily subscribed despite the fact that its yield was the lowest point it has been for the last four years. These are challenging times; the appeal of the US as a safe haven for money market investors remains considerable. Strong global demand for US Treasury securities has depressed yields across the board but even a 150bps yield, it turns out, remains attractive to today’s investors.

Can you describe the forthcoming US regulatory reforms and their likely impact?

There are two upcoming near-term events to bear in mind. The first, which is already having an impact, is the impending reform of the US money market fund industry. From 14 October a new regulatory regime covering money market funds will see prime funds publish floating NAVs and introduce exit fees and gates. The changes will, for the first time, allow money market funds to ‘break the buck’.

The result has been a massive flight to safety that is set to continue. By 14 October it is likely we will see the vast majority of (securities finance industry) money shift out of prime funds, which have a more open investment mandate, to funds with investments limited to government securities.

Estimates of the size of the transition vary significantly from $300bn to over $1 trn, with an estimated $500bn already having been transitioned, according to analyst reports at the time of writing. The shift to government funds will absorb large amounts of high quality liquid assets (HQLA). For the securities finance industry, the effect already observed is declining weighted average maturities and rising term fees, a shift that is already being reflected in the LIBOR rate.

This is not the only change that will affect our industry. Effective 3 October, the Fed’s Overnight Bank Funding Rate (OBFR) will replace the Fed Funds Open (FFO) rate as the key benchmark for pricing and performance reporting. The OBFR is a calculated rate that, generally speaking, also includes certain euro deposits to provide a broader measure of demand.

This is not the only change that will affect our industry. Effective 3 October, the Fed’s Overnight Bank Funding Rate (OBFR) will replace the Fed Funds Open (FFO) rate as the key benchmark for pricing and performance reporting. The OBFR is a calculated rate that, generally speaking, also includes certain euro deposits to provide a broader measure of demand.

What dynamics are shaping the fixed income space currently?

The striking trend here is the elevated demand – and elevated fees – for HQLA, especially the shorter durations. There’s also evidence of fails, which are driving rates significantly higher over maturity or re-issue periods.

All this amounts to a significant shift from recent years. Until relatively recently, the government bond space was characterised by high volume, low margin general collateral trades that did not, on the whole, generate meaningful returns. Now, particularly at the shorter end of the curve, you are occasionally observing rates in excess of fail cost. 

Strong demand for sovereign debt isn’t just a US phenomenon: the heightened demand for term-upgrade trades, and the elevated fees associated with these, is a feature of termed HQLA across Asia, Europe, Canada and the US.

Another observable trend is lower issuance in US convertible corporate bond markets. At roughly mid-year 2016, issuance was down 44% year on year2 with a recent uptick of issuance in August. General US Corporate issuance, however, is now up 5% year over year3. After the Bank of England rate cut, its first in seven years, investment grade issuance surged the week of 8 August. High yield issuance also rose, with issues linked to distressed market segments such as oil.

Globally, the move by the ECB in June to extend its quantitative easing operations to include corporate bonds has provided additional challenges to liquidity. Consequently, with higher utilisation rates and higher fees, this remains a very active space, something that we expect to continue.

How far – and where – is the shift to non-cash collateral advancing and what are the implications?

The numbers are clear: the non-cash market has been growing in the US for a number of years to approaching half of the total market today. In Canada or Europe, where the shift has been in the other direction, the growth of cash collateral has been slower. But it is important to note that, within North America, Europe and Asia, the rate and scale of change differs from region to region. This is a function of varied regulatory environments and diverse market conditions.

In the US, for example, it is clear that new regulations – notably the anticipated introduction of the Net Stable Funding Ratio (NSFR) under Basel III – are driving participants towards termed non-cash transactions. Market participants are further keen to correlate their trades, meaning for instance a shift towards like-for-like when it comes to the currency component and away from mixed currency transactions.

Non-US funds enjoy certain advantages in permissible non-cash collateral acceptability versus their US counterparts. This dislocation is being addressed with the pending reviews of US rule 15c3-3 that, for instance, currently prevents US-based broker-dealers from pledging equities as collateral to agent lenders. Similar reviews are underway exploring equities as eligible collateral for ERISA and ’40 Act funds.

This has obvious pricing implications of which beneficial owners should be aware. The natural instinct for borrowers is to deliver the collateral they are naturally long in, in order to most effectively contain financing costs. For example, given the recent rally in global equity markets, this means a keenness on the part of many to post equities. But there is a clear case to be made for a diversified pool of collateral: if structured correctly this can improve a lender’s risk profile while earning above average returns. At the core is the underlying responsibility to operate a programme in a skillful and prudent manner and be diligent in the fees you charge.

What opportunities can blockchain provide the industry?

This is an interesting and important development, which firms should not ignore. Blockchain is coming to our industry in some form, and sooner than you think.

There is no shortage of analysis being done by the big banks, investment firms and accounting firms. Many of the large Wall Street firms are committing considerable investment dollars to maximise the opportunity and minimise the threat posed by blockchain. Approximately 50 financial firms have joined up with the R3 Distributed Ledger Group to investigate the role of blockchain technology in the financial services industry

However, precisely what the impact will be, and how and where it will be focused, is hard to predict. Much is made of the potential for blockchain to disrupt the industry status quo. This is true, but it could equally enhance efficiencies and save costs for existing participants. If we are alert to the opportunity, the benefits could be significant and wide-ranging: in theory, blockchain has the potential to touch any process that is principally a ledger-based technology with a rulebased wrapper, across cash trading and settlement, to FX and beyond.

It is important to stress that we haven’t seen any significant tangible impact yet – efforts are still largely in the planning stage. At first, I think that we are more likely to see piecemeal opportunities – ‘rifle-shot’ chances to take low-hanging fruit, for example – than single big-bang type transformations.

While there may be advantages accruing to early adopters, much work will have to be done behind the scenes before blockchain’s commercial potential can be realised. Technically, users will need to grapple with how the technology can be embedded into existing processes. Blockchain raises questions, for instance, around legal and contractual considerations for privacy.