Harsh regulatory restrictions on retail funds means the importance of institutional lending has never been greater, ISLA says in its latest report.

The securities lending trade body says tougher rules on retail funds, notably UCITS, has led to a “permanent shift” in borrower behavior.

Prime brokers and hedge funds are now clearly looking to borrow securities from entities that better match their own regulatory requirements.

ESMA's rules on collateral diversification and asset segregation for UCITS funds has reduced their lending activity.

Meanwhile, Ireland, a key UCITS fund domicile, has placed minimum credit ratings on any counterparty involved in a securities lending trade.

Although mutual/retail funds still account for 44% of all securities made available for lending, they now make up only 17% of total on-loan balances.

“We would conclude this disconnect is still for the most part due to the restrictive regulatory environment that UCITS face in Europe," ISLA notes in its report. 

At the end of June this year, 38% of all government bonds on-loan came from government and sovereign wealth entities, up from 34% six months earlier.

ISLA claims most of that proportional growth would appear to be at the expense of mutual/retail funds including UCITS which fell to 15% of all loans of government bonds at the end of June this year compared to 18% in December 2015.

On the other hand sovereign wealth funds now comprise 7% of lendable securities but continue to report a disproportionately high 13% of all securities on-loan.

“With the continued regulatory restrictions on retail funds, we have noted the growing importance of this institutional lending group in this and previous reports,” ISLA notes.

The comments follow a recent BNY Mellon study suggesting that sovereign wealth funds are looking to expand their use of securities lending.

Other key points in ISLA’s 5th Securities Lending Market report

• €1.9trn of securities on-loan globally at the end of June, 2016. That's an increase of 4% from six months earlier.
• The value of equities on-loan continued to increase in the first half of the year powered by increasing demand from Asia and North America.
• Contraction of lending activity around the UK Brexit vote on 23rd June. European equity loans were returned ahead of the vote, suggesting investors had closed down open risk positions..
• Mutual funds and pension plans continue to dominate the global lending pool. Together they again account for 66% of the reported €14trn of securities that institutional investors make available for lending.
• Europe continues to record much higher levels of non-cash collateral as banks and brokers repositioned their balance sheets to comply with new regulations. In excess of 90% of all government bonds which are lent in Europe are now collateralised with non-cash collateral.
• North American equites continue to dominate representing 67% of all equities on loan as at the 30th June.
•  Basel III and the Liquidity Coverage Ratio (LCR) have created a term market in HQLA that didn’t exist two years ago. ISLA now views this as a permanent feature of the market.
• Further regulatory pressure could continue to push institutional lenders away from the securities lending market. The combined and rolling impact of compliance with various regulatory regimes such as SFTR, (BRRD), CSDR and further restrictions on UCITS, may cause some lenders to withdraw from the market rather than comply with this array of new regulation.