Taking stock

A review of the main factors behind the growth of securities finance revenues in North America in the second half of 2022 - a period during which the main US indices lost more value than at any time since the 2008 financial crisis.

S&P Global’s securities finance snapshot for May 2023 shows that across Canada, revenues increased 4% year-on-year to $32.8mn (£25.6mn). This represents a decline from April ($39.4mn), making May the second lowest revenue generating month of the year for the country.

Revenues were driven lower by a fall in balances over the month (-$12bn) as average fees remained close to those of April.

Revenues from specials decreased 15% to $9.2 from $10.8mn in May 2022 and specials balances were approximately 1.7% of all on loan positions. Specials activity in Canada has generated $50.5mn so far this year, a 31% increase on the same period in 2022.

IHS Markit’s securities finance Q1 2023 snapshot notes that the Bank of Canada increased rates once over the period - by 25bps - but communicated that it would be pausing for breath after this most recent hike. Tech stocks saw the greatest gains over the quarter with mega cap stocks experiencing the strongest returns.

Average fees in Canada over the period were 69bps, which represents a 17% increase over Q1 2022. Final Q1 revenues for the quarter were $107.6mn and March was the best month for Canadian revenues with $40.4mn generated. An impressive average fee of 72bps (+15.8% year-on-year) helped push revenues higher.

Ross Bowman, global head of agency lending client management, securities services at BNP Paribas observes that 2022 was the worst performing year for the US S&P 500 index since 2008 and the fourth worst since 1957.

Equity valuations

Markets were panicked by high levels of inflation and increasing interest rates, and with equity valuations trading on multiples of future earnings, value stocks soon began to outperform growth (more speculative) stocks.

By the end of last year, the NASDAQ had posted a 32% year-on-year-decline, the S&P 500 an 18% decline and the Russell 3000 Growth a 29% decline. However, with the exception of the NASDAQ, the final quarter of the year did see all the main US indices posting increased returns quarter-on-quarter on the potential positive note that inflationalthough still high - may have peaked around year-end. However, this tumultuous period ended with benchmark interest rates in the US at a 15 year high.

“In terms of securities lending activity, the dramatic increase in interest rates has meant that market investors that have historically sought yield through growth stocks and riskier investments can now benefit from reasonable yields on risk-free and much less risky assets, such as government and agency bonds, which has driven down values and hit corporate earnings,” says Bowman.

These downward moves in cash equity values have increased the level of directional short activity in the US securities lending market. Even the big tech growth stocks of Meta, Amazon, Apple, Netflix and Google lost a collective 43% in value over 2022, with Tesla printing a 65% loss in value.

“With these heavyweight constituents taking large valuation losses, many other stocks have followed which has created volatility in the markets and therefore opportunity in the securities lending market,” says Bowman. “According to DataLend, this increase in activity and revenue has resulted in the North American equities markets outperforming all other regions over the year, with an 11% increase in fees.”

Top specials

The top five earnings security specials of 2022 were all in the US market, generating $769mn in revenues for lenders, $356mn higher than the top five specials of the previous 12 months. Overall, specials volumes increased in the US as monetary policy has driven the downward trajectory of cash equity market valuations throughout the year, explains Bowman.

“Increasing global inflation and benchmark interest rates have hit the pockets of consumers as wages have struggled to keep pace,” he says. “These macro factors have not only created volatility in the financial markets - increasing specials activity - but consumers have also become less able/more hesitant in their spending on large ticket items such as automobiles, right down to smaller items such as renewed subscription services and tech upgrades.”

On average over 2022, fees for government bonds increased year-on-year, although overall utilisation was lower than in 2021. Borrowing demand for US government securities was directly driven by increasing US inflation and the Fed’s interest rate increases to try and control it.

“Outside of the usual demand for the cheapest to deliver (CTD) and benchmark issues, the greatest borrowing demand remained concentrated in shorter dated issues, as these are more sensitive to rate increases,” says Bowman. “Furthermore, the looming spectre of the US debt ceiling continued the demand for shorter date US T-bills.”

DataLend’s Q1 2023 market review notes that regionally, the bulk of the revenue increase came from bonds issued by North American corporations, generating $124mn in lending revenue, equivalent to a 96% increase compared to the same period in 2022.

This impressive performance was primarily driven by a 92% increase in fees year-on-year. On the other hand, falling bond prices were counterbalanced by a 13% increase in the onloan quantity of corporate bonds, resulting in balances remaining flat.

Revenue drivers

The largest revenue generating corporates in the region were SIX FLAGS 5.5% 15/04/2027, MPH A LLC 5.75% 01/11/28, and MICRO 0.125% 15/11/24 with a combined revenue of $8.9mn.

Most notably, SIX FLAGS 5.5% 15/04/2027 revenue was up over 6200% compared to Q1 2022, with fees and on loan balances up 2,777% and 121% respectively. At an issuer level, SIX FLAGS was the number two

US meme stocks, Lucid Group (LCID), video game retailer

GameStop Corporation (GME), and food producer Beyond Meat Inc (BYND) were the top three revenue generators in 2022. Together these three securities produced over $570mn in gross revenue, twice the revenue generated by the top three in 2021

Nancy Allen, Equilend

revenue generating company, although there may be a short play on the one issuance maturing in 2027 as all other issuances traded GC and the common stock (SIX) has seen low demand for an extended period.

3M COMPANY issuances took the top spot, with combined revenue of $5.7mn spread out across four issuances all earning more than $500,000.

Nancy Allen, head of data & analytics at EquiLend observes that 2022 was another banner revenue year for the securities lending community as the market generated nearly $10bn in gross revenue for beneficial owners. Regionally, North America experienced a 10% year-on-year revenue increase due to strong fixed income performance and an uptick in equity revenue of 7% on the back of higher fees.

“US meme stocks, Lucid Group (LCID), video game retailer GameStop Corporation (GME), and food producer Beyond Meat Inc (BYND) were the top three revenue generators in 2022,” she says. “Together these three securities produced over $570mn in gross revenue, twice the revenue generated by the top three in 2021.”

Allen adds that US interest rate hikes helped to drive corporate debt performance in the lending market - from a revenue perspective, the top ten corporate bonds demanded fees 54% higher than the 2021 average, driving US corporate debt revenue to double year-over-year.

Growth factors

When asked to outline the main factors behind the growth of securities finance revenues in North America in the second half of 2022 - a period during which the main US indices lost more value than at any time since the 2008 financial crisis - Betsy Coyne, senior vice president client relationship management at eSecLending observes that volatility resulting from inflationary concerns, geopolitical issues, a reduction in hedge fund net leverage, and an active economic environment led to more short selling and directional activity in the latter half of last year.

“One of the main contributors to revenue growth was the shift in the interest rate environment,” she explains. “We saw robust reinvestment opportunities for those lenders with guidelines that allow them to take advantage of the favourable conditions. Also, US treasury ‘specials’ came back into the market after a very muted 2021.”

On the equity side, eSecLending’s on-loan balances hit a five year high and average fees moved favourably from 50 bps to 60 bps on average at the end of 2022. Another positive sign was that specials were more broadbased. The risk-on environment and notable disparity among market participants in terms of where the economy was headed provided for lending and financing opportunities.

Valuations of everything growth-related or speculative in nature came under pressure given the rising rate environment says Coyne.

“Specials activity in 2022 was largely attributed to US equities and the meme stocks such as GameStop, Beyond Meat, and Sirius XM Holdings. Also contributing to the specials activity were sector plays such as the EV space (for example, Lucid Group) and crypto related names such as MicroStrategy. We also saw incremental revenue in the US high yield ETFs space as well as names like AMC Entertainment.”

ETF activity

US ETFs dominated lending activity last year and were popular among investors. ETFs were borrowed for directional plays largely because they are easier to short than the full index and provide broader market exposure.

“We saw heavy shorting of ETF names earlier this year but that has cooled a bit,” says Coyne. “Although fees are off compared to last year, ETFS are still generating good returns, particularly sector or index specific ETFs.”

Monetary policy has impacted demand for US government bonds in a variety of ways. In general, rising rates have given repo investors (mainly money funds) an upward sloping yield curve and a place to park idle cash, with money market fund AUMs reaching historic highs in the post-pandemic environment.

“As repo balances increase, we are seeing demand for GC collateral as many borrowers are running a match book - bidding in collateral at one price and offering collateral at another - and clipping the spread (bid/ ask) on these trades,” says Coyne. “GC lending of government bonds has increased as rates have increased because lenders are more willing to pay a rebate to raise cash when there are good spending opportunities on the reinvestment side. As rates have increased, we have seen more of these opportunities arise.”

Although demand remains strong for collateral, the continued increase in rates is weighing on the overall rebates that are being paid to lend USTs and borrow dollars.

“The cost of the 2% haircut in securities lending trades is more punitive to borrowers in a rising rate environment and we are starting to see this cost increase passed through to our bids,” adds Coyne.

“The rising interest rate environment has aided the demand in the specials market because, as rates increase (and prices decrease), we have seen the short base in the on the run issues increase. As the Fed’s quantitative tightening programme continues we are seeing less securities held in the SOMA (Fed portfolio) account, and hence less available outlets for borrowers to source supply.”