Market to receive EMU-boost
The introduction of the euro will have a major impact on the securities lending business. Economic and monetary union will likely lead to increased trading activity in both the bond and equity markets across Europe through the reduction and stabilisation of interest rates and inflation, as well as the removal of FX risk through the introduction of a common currency.
The resulting increase in liquidity is likely to mean the development of new trading strategies and options. Also, increased securities lending demand coupled with the anticipation that collateral restrictions in certain government bonds will be lifted, may potentially reduce the cost of borrowing through greater collateral flexibility.
In addition, collateral margin requirements may be reduced through reduced price volatility and the elimination of FX risk, further reducing the cost of borrowing. A current common scenario is one of a Dutch lender making Italian equity loans and receiving German government bonds as collateral. This creates a risk of being under-collateralised due to fluctuations in both the securities and FX markets and has necessitated a margin on collateral (typically 5%) to cover this risk and to minimise the volume of daily market to market transactions. The standard margin in the US or UK domestic treasury markets, in which there is no FX risk and volatility is low, is currently from 0% to 2% for US treasuries and 2.5% for UK Gilts, as compared to margins on loans of international securities of 5%.
The single market may also reduce legal obstacles to lending in Europe (eg Italian insurance legislation and Irish lending restrictions). The ultimate possibility of legislation standardisation across the euro market could signal the opening of new markets and the entry of new lenders, providing an increas-ed supply to feed a growing de-mand.
The potential harmonisation of taxation across 'Euroland' has been declared 'inevitable' by some analysts and commentators. This opinion is not a universal one, however. There is widely held opposition to tax harmonisation by UK business, since one of Britain's competitive advantages is its relatively low corporate tax rates.
Talk of a single European central depository and automated clearing house is still an abstract concept, but the potential benefits in terms of reduction in settlement costs and transaction efficiencies would be immense. EMU sets the stage for this concept to become a reality.
Further, it could be asked what is the likely impact on London's current status as the centre for international securities lending, in light of the fact that the UK is an out-country. The brief answer is that the euro is unlikely to diminish the role of London since traders will still use London as a safe place from which to view the impact of changes in Europe. Longer term, however, is the impact of recent mergers and agreements between various country stock exchanges.
These may well cause some changes in European, and possibly global trading practices, which may ultimately impact international securities trading.
Following January 1, 1999 some or all of the European Union 'out' countries (Denmark, Greece, UK, Sweden) will decide whether or not to join the EMU. A UK decision to join would have a significant impact on securities lending since a sizeable percentage of loans and collateral are presently denominated in UK bonds. Should the UK decide to join, a large conversion effort similar to the one necessary over Le Weekend 1998 would be required. The other 'out' countries conversions would have less impact since fewer loans and collateral are denominated in these currencies.
It could be argued that, compared to the mature US market, securities lending is still a developing business in Europe with huge potential for further growth. This growth may be in fact, fuelled by the introduction of the euro. It is clear that considerable opportunities and challenges lie ahead for investors who lend securities. Lending banks with expertise in international lending and knowledge of local markets will be well placed to support investors through the coming transition period.
Michael Valentine is securities lending product manager at Citibank