Robert Chiuch, Global Head of Equity and Fixed Income Securities Finance Trading at BNY Mellon Markets, explains how the sector has prospered in spite of a tough recent macro environment and discusses the likely impact of recent technological innovation
How would you characterise the performance of the sector so far this year and how does this augur for the future?
The strong performance of securities finance across all segments so far this year, has occurred in the face of some recurring headwinds. Starting with the positives, the US has obviously enjoyed robust economic conditions over the past 12 months, and that has been complemented by a more positive regulatory environment generally.
More particularly, we have seen increased securities finance activity and climbing on-loan volumes due to the ongoing impact of the US tax reforms late last year, rising interest rates and some diversion in the policy decisions being taken by central banks around the world. That said, the marketplace has still encountered some challenges.
One significant factor has been the flow of M&A opportunities. Activity in the M&A sector has attained record levels – reaching roughly $2.1trn so far this year, with roughly half of this concentrated in North America. However, many of these have been cash deals, as corporates have looked to find a home for the large cash balances repatriated in the wake of the tax reform passed by Congress in December.
Declining returns from global equities was another headwind this year. After a great 2017, the S&P500 has had a tougher 2018 so far. For the US, the high concentration of equity gains in a few key industries, notably technology, financial services, and health care, means that a hiccup in any major sector can have a big impact on the value of the rest of the index. European market indices have followed a similar course, as have those in Asia.
My point is that while price gains in securities on loan obviously translates into increased income available from those trades, these sluggish index valuations have a knock-on impact on industry revenues. It is therefore particularly noteworthy that - assuming stable reinvestment rates - real growth for securities finance this year has been strong, comfortably outpacing price gains in the S&P500 and other markets.
A further challenge has been presented by the strong US dollar, which has strengthened a little over 6% against the Canadian dollar and roughly 7% against the euro over the past six months. This strength has shrunk the real value of overseas revenue from securities finance programs for some US firms.
What all this means for the coming year is hard to say. Besides tougher valuation conditions, there is the question of where US economic growth is headed, with many commentators questioning how long the strong recent US GDP data can be sustained.
What does the current tightening cycle mean for fixed income trading?
While the ECB left interest rates on hold on July 26, it is continuing to unwind its QE policy. It has also reaffirmed its commitment to halving its monthly bond purchases from €30bn to €15bn in September before ending them entirely in December.
We’re also seeing monetary tightening happening in the US, with the market predicting two further rate rises in 2018. Of the major central banks currently tightening monetary policy, the BoJ remains the exception, leaving rates unchanged while introducing forward guidance for the first time by declaring that “extremely low” interest rates would remain “for an extended period of time”.
The combination of tighter monetary policy and tax reforms in the US are having a significant impact on the
corporate bond market in particular, which has traded in a relatively narrow range since the middle of 2016. Meanwhile, recent evidence in short-term investment grade bonds points to demand for inventory exceeding supply.
The US tax break, which provided for significant repatriation of company profits, has put downward pressure on new debt issuance since corporates flush with cash have no need to issue bonds, and this will work to depress spreads further.
Over on the sovereign and quasi-sovereign bonds side, meanwhile, that market continues to enjoy a period of structural strength, further driven by global bdemand for HQLA.
Ultimately, I would say securities finance has learned to prosper in a low-yield environment, as recent enhanced returns testify. Certainly, there will be a transition period through the current phase of policy adjustments but, as resets occur and things normalise, we can look forward to higher interest rates improving spreads.
What has been the impact of CCP reforms?
CCPs have now established themselves as an important work stream for nearly all market participants. We have been particularly active in the Eurex CCP, working hard to facilitate its launch, acting as early adopters and encouraging migration onto the new platform for a range of customers.
In general, however, while global regulatory reform has indirectly incentivized cleared repo and securities lending, in practice the adoption of CCPs has been slower than many anticipated. The principal reason for this has been the operational challenges required to connect and transact.
With hindsight this may not be so surprising. New initiatives always take time to bed down. Participants must be educated regarding the benefits of connecting and given time to familiarise themselves with a CCP’s rules. Even after systems go live there are typically teething issues and getting participants on board entails navigating a range of differing operational challenges. On balance, I think CCPs need to be viewed not as a panacea but as one of several tools in the toolbox. They have become an important element of our business, but while they will be useful to some, we realise that they may not be useful to all.
Does the fintech revolution represent a risk or an opportunity for incumbents like BNY Mellon?
While ours is a business with relatively high barriers to entry –including large capital and infrastructure requirements– the relatively unencumbered fintech sector is growing at remarkable speed. Through the innovation that emerging players create, and the pressure they put on existing providers to improve, the long-term legacy of the fintech era will be more liquidity, improved transparency and quicker, smoother execution.
We’ve already seen that certain sections of the market, such as pre- and post-trade processing, have proved particularly well suited to this sort of innovation. We’re also continuing to see innovation in the GC space.
In general, the impact on fixed income lags that seen in the equity space so far, suggesting that it is an area where we could yet see further innovation. Certainly, incumbents need to keep abreast of the competitive forces being unleashed by this new wave of financial innovators. However, whether their impact will be achieved through consolidation or fragmentation is hard to say.
One outcome could be a barbell effect, with providers increasingly bunching at either end of the scale in terms of size, capital resources and specialisation. Such a scenario would comprise, on the one hand, a small number of one-stop shop firms, that have achieved scale through consolidation and for which superior capital resources facilitate an improved service in certain sectors, which customers favour. On the other, you could see a number of more specialist niche providers targeting specific segments and functions, where their technological innovation offers customers compelling value.
However things pan out, I think there is a general point to be made concerning large firms. Those incumbents that are able to harness the current tide of financial innovation will be those who make the best use of their existing competitive advantages.
Crucial among these is their proximity to customers and familiarity with customers’ needs. Customers look to their major providers to interpret, filter and curate the current innovation, but only because they have the resources and experience to perform these services well. As soon as customers begin to question providers’ skill in separating the wheat from the chaff, I think this advantage is likely to disappear.