Why securities finance will grow in profitability over the next year

Zimbabwe’s economy reported inflation running at 3.2% at the last count. The UK reported 3.7% against a target of 2%. Incredible. Inflation is the enemy of central banks but the friend of US Custodians because rising interest rates will help improve the income from the cash collateral that is raised against loaned securities. With at least $1 trillion to benefit from higher short term deposit rates there is much at stake. For those whose glass is always half full rather than half empty, this presents one of the core arguments as to why the future is bright for Securities Finance. Ahead of the opening discussion at our London Securities Financing Forum on the 16th March, I will present the two sides of this (devaluing) coin. Today is the optimistic scenario due to buoyant markets, more assets in Hedge Funds, more convertible bonds, more dividend payments, more M&A, regulatory clarity and why financing is useful to be BASLE III compliant.

The markets are pricing in three interest rate rises for the Pound. The ECB President is making noises about being tougher on inflation while Korea and Poland have recently raised their rates by 25bps. With only 19% of total securities lending revenue coming from the interest on the cash collateral, there will be a major boost if this changes. The winter of discontent for Repo traders could be ending.

The buy side will be putting on more short sales and therefore borrowing more stock. With the main equity indices up around 10% last year and up strongly this year (S&P400 at all time high), there are gains to lock in. Rather than selling to protect profits, Hedge Funds may engage in more shorting since their portfolios have further to fall than this time last year.

Hedge Funds saw huge inflows of money in the third quarter of 2010. UCITS III funds are gaining traction. The recent Keplerpartners.com report showed an 85% increase in Long Short funds in this format and a total of 180 single manager funds with $60bn AUM, having begun the year at a little over $20bn.
Convertible bond issuance is crucial to borrowing and lending demand. According to dealReporter.com, Asia is where this is most likely with a net $1bn of new issuance last year ($14.7bn issued with $13.7 redeemed). The success of China Unicom’s CB issue, the second largest Telco in China, and the fact that issues were more than five times covered on average in 2010 means there could be many more. Rising interest rates and more stringent capital reserves required at banks will dent their desire to lend to fund corporate cash requirements, forcing companies to tap the bond markets and CBs, if appropriate.

As we know, a crucial moment for the profitability for most people in the Securities Finance chain is the spring dividend payment period. Companies are awash with cash having cleaned up their balance sheets but nervous (unless their name in BHP Billiton) about spending it on takeovers. Shareholders argue for greater dividends as well as share buy backs. Greater dividend payouts mean more demand in the securities lending market as Beneficial Owners seek to optimize the percentage of the income they are able to keep and re-invest from this dividend bonanza.

There is predicted to be more M&A this year but we need to see more takeovers financed by a combination of cash and stock for this to interest the arbitrage community and stoke the fire of the lending market. There are 58 live deals in the US according to dealReporter.com adding up to a combined value of $190bn. 36% of these deals are in the medical and bio-tech sectors which is interesting to know for those looking to match lending supply with borrowing demand. This is at a one year high which bodes well.
There are angles to changes in regulation that can be given a positive spin. It helps that Christopher Cox (past head of the SEC) is on record saying he “regrets” banning short selling in financials. It helps that independent academic research back this up. It also helps that regulators are going for disclosure rather than banning short selling outright. To borrow a line from Professor Michael McKenzie (University of Sydney): this industry is its own worst enemy until such time as its activities are “on the table”. It is unfair that Hedge Funds have to disclose their short positions, when funds going long do not but the novelty of these announcements will soon wear off and cease to become news, leaving funds uninterrupted to make decent size short bets.

Finally, on the optimistic side, do not tremble at the thought of BASLE III. Efforts to increase the capital adequacy of banks are here to stay so adapt or die. It is time to draw on the basic function that Securities Finance serves – managing the liquidity of a bank. All power to the team who can help manage liquidity and offer term financing to meet the needs of the future. After all, hasn’t the depositing of eligible collateral against the receipt of cash (i.e. Repo) been the instruments of choice right now for the central banks to pump short term money where it is needed most?
If you disagree, come to the London Forum to say why! www.dataexplorers.com/london