The future of Securities Finance (judged by the last 3 weeks)

It is unusual to make predictions based upon the ides of summer. But, this summer has been a watershed (and very watery if you spent it in England) on so many fronts. Most of the mouths that are fed by securities finance have had their immediate future clarified. We will look at ETFs, convertible bond arbitrage, the growth of UCITs III hedge funds and interest rates.

How was your holiday this summer? Spend most of the time on the phone to the office? Cut it short like every European President? Despite the roller coaster of the last two weeks and the (futile) short selling bans, the good news is that we know where we stand, starting with a 3 letter acronym called LUV.

Interest rates

Sir Martin Sorrell of WPP (LSE:WPP) thinks LUV is in the air. This means that European economies will have a long L-shaped recovery, that America will rebound more quickly in a U-shape, while emerging markets will snap back the fastest in a V-like fashion. If true this means USD interest rates are not set to rise anytime soon and Bernanke has said as much. The c.USD 1 trillion* of cash generated by securities lending and subject to benefit from higher interest rates looks set to struggle to generate more than the 0.9bps that it currently generates (return to lendable). Intrinsic securities lending fees or rebates today contribute 84% of the total revenue and it is going to take some very clever cash management strategy to change this with no help from the Fed. We need to get used to low interest rates.

ETFs

The balance on loan for ETFs is close to the 12 month high with USD 50.6 billion borrowed. Their contribution to the daily equity traded volume is staggering. In normal times ETFs are 30% of daily US equity turnover but this rose to 40% in recent weeks with SPY (SSGA’s S&P 500 ETF) and IWM (iShares’ Russell 2000 ETF) together forming over 10% of all equity volume. ETFs have been the chosen instruments to trade this market. As retail investors scramble and end up selling low and buying high (hard to avoid this recently) and as hedge funds hedge their long bets, ETFs have seen record trading volumes. Aside from the obvious benefit to those with ETFs to lend, still mainly the broker dealers, there is also the creeping importance of the Delta One desk that can trade the inefficiencies between these instruments and the baskets they track. In a good piece in this week’s Financial News (http://www.efinancialnews.com/story/2011-08-22/demand-for-etfs-continues...) they point out that, ‘once the poor relation….Delta One is fast becoming an important source of equity profits.’

Convertible Bonds

Dealogic have come out with the latest AUM figures for this short selling hungry strategy. Bad news: issuance of new convertible bonds is the lowest for 6 years at a predicted USD 86 billion this year (53.8 done so far http://www.efinancialnews.com/story/2011-08-22/convertible-arbitrage-off...). But I predict that we will soon see new issuance pick up. It is no problem for Walt Disney and Coca-Cola to issue investment grade debt at wonderfully low interest rates. In fact, all blue chip companies would be wise to issue debt at a time when investors would prefer corporate to government counterpart exposure. But, less secure firms might also issue debt and a convertible element could make all the difference with share prices as low as they are. In 2009 nearly USD 100 billion was issued in this asset class by way of comparison. What does this all mean? Low leverage and a lack of investor appetite for convertible bond arbitrate and a lack of new suitable bonds all point to suppressed demand to short sell. This could change however.

UCITs III and Hedge Funds

And what of the growth of these hedge funds for retail investors? There are plenty of new UCITs III hedge fund launches. A big new one would be the Schroder’s/GAIA/Egerton Euro Equity with USD 526m in AUM (http://www.absolutehedge.com). There are about 250 of these hedge funds available to UK investors with just under USD 90 billion in assets. The total could be as high as a 1000 funds depending on the definition you go for. Clearly, this area is growing and is set to have put on plenty of new shorts over the past few weeks.

This is going to be a key year for the whole hedge fund industry. If such funds can show an ability to keep their heads above water in a way that long only managers cannot then the world will be their oyster. The Hedge Fund Intelligence composite index is up 1.14% in the year to the end of July with equities up just under 1% for that period. This was unremarkable compared to many benchmark indices but August will be a landmark month to judge. It could herald a return to favor for the market neutral funds who are heavy short sellers. On the flip side, it can’t have been easy to have been a quant fund recently. Even those with a heavy short exposure will have suffered in August in the collapse in equity markets and this leaves funds with 4 months in which to excel and get paid. Will this mean a gradual uptick in leverage and risk appetite?

Recent Securities Lending volumes

There has been a 9% increase in securities lending transactions in the Russell 2000 reported to Data Explorers in the past 4 weeks compared to the same time period last year. In Asia, this is a 19% increase although this slightly reflects the growing amount of data we are capturing in this region. As can be seen from the table, there was a healthy increase in new loans in June.

North American Equities, June 2011

• DXL borrowers new loans : 291,299
• DXL lenders new loans: 1,367,014 

North American Equities, Jan to June 31st 2011

• DXL borrowers new loans : 1,552,749
• DXL lenders new loans: 7,106,803

North American Equities, Jan to Dec 31st 2010

• DXL borrowers new loans : 2,494,125
• DXL lenders new loans: 16,089,574

Final Word

It is ridiculous to suddenly think we have a crystal ball after these mad few weeks. But, as businesses budget for next year, some predictions are better than none. And, in the same way that you can see color and distance more clearly after a storm, I speculate that this could be the same here.

Note: Of the $1 trillion reported to Data Explorers as loans collateralized by cash, 650 billion is reported as re-invested in pursuit of extra income so if we account for that part of the market we do not capture you get a figure of no more than 1 trillion.