The fanfare accompanying the launch of the euro created great expectations for the securities lending business. The ultimate prize of a truly pan-European capital marketplace would accelerate the growth of cross-border securities lending. That said, many traditionally conservative securities lenders are now tempering their expectations to a more evolutionary rather than revolutionary approach. Recent trends indicate that a pan-European securities lending market is slowly, but surely, coming of age with lenders increasingly accepting euro-denominated collateral and borrowers moving towards euro financing.
Management of the Euroclear securities lending program has allowed us to witness several interesting market trends, both before and after the launch of the euro. As shown in the diagram, the overall trend is that there is a clear increase in the proportion of euro-denominated loans in our program. The program is itself relatively unique in that unlike many ‘street’ lending desks focusing on demand arising from trading or arbitrage strategies, our securities lending specifically targets loan demand to avoid settlement fails.
The program has been providing attractive returns to lenders since 1975, currently averaging over $7bn of securities loans outstanding each day. Participation in the lending
program is very attractive to conservative investors and central banks, among others, due to built-in protection against borrower default, and a
low reinvestment and counterparty
risk environment.
After the anticipated 1998 year-end decrease, the daily volume of domestic security loans outstanding rose by 85% from December 1998 to June 1999. In our experience, the driving force behind the substantial increase in loans outstanding comes from the two largest markets, borrowers of French and German securities. Loans outstanding in Germany grew steadily from December 1998, in fact doubling in size by June 1999. This amount equals the peak observed in Germany at the height of the Asian crisis last year. For France, the evolution has been different. Loans outstanding until December 1998 were flat with no noticeable pre-euro impact. Then, in January 1999, they rose sharply by 46% and remained flat until June 1999.
This trend does not really come
as a huge surprise. The Maastricht Treaty criteria, stipulating stringent debt/GDP ratios and the maintenance of a debt deficit of under 3%, has slowed down the growth of the European government bond market. This means that the available lending supply of sovereign debt will remain more or less constant. However, trading volumes are soaring and traders need to find highly rated,
liquid issues to support their trading strategies. As this demand rises and the supply remains unchanged,
it becomes more difficult to find the required securities. The increase
in trading activity will put additional strain on securities realignment, delivery and settlement functions. Therefore, the end result is that
settlement-related loans will
continue to rise.
Interestingly, the volume increase in loans outstanding is concentrated on sovereign issues, whereas we see no increase in domestic corporate debt. This may seem strange, as we were expecting an increase in European corporate debt issuance. However, what we found is that European corporates are taking advantage of the extra liquidity provided by the euro and are therefore moving from traditional domestic markets to international markets for financing purposes.
The trend for euro-denominated loans in eurobonds is worth examining, especially when compared to the trends in US dollar and in EMU-out currencies. From December 1998 to June 1999, the total loans outstanding in eurobonds has remained relatively flat. However, there has been a significant shift in the currency distribution as US dollar and EMU-out currencies both lost market share to the euro. To this end, the proportion of euro-denominated loans in eurobonds has increased from 20%
in December 1998 to over 30% in
June 1999.
Another interesting trend is the shift in euro-denominated eurobond corporate debt lending which increased by 81%. Corporate issuers naturally want the best possible financing conditions. By issuing eurobonds through an International Central Securities Depository,
corporate issuers are able to attract both national and pan-European investors while retaining all the benefits of issuance in a single currency. This has a spin-off effect of increasing securities lending opportunities for these types of securities.
The evolution of monthly average overnight money market rates has not been too favourable for lenders. The dollar rate went from 5.22% in December 1998 to 4.76% in June 1999, representing a 9% decrease. The euro interest rate plunged by 26% over the same period (from 3.35% to 2.49%). These trends have negatively affected lender returns. However, this impact has been partially offset by an increase in the volume of loans outstanding. The good news is that the euro and dollar rates are on the rise, with the one-year overnight forward rates set at around 3.5% and 6%, respectively. So, with rates on the rise and euro loans continuing their steady growth, the year 2000 looks set to be a much better year for lenders, perhaps one of many to come.
Additionally, the markets’ shifting focus from country-based investments to pan-European, sector-based portfolios, is placing greater emphasis on equities. Although there has not been any marked enthusiasm for settlement-related equities borrowing, we could soon start seeing exponential growth in this market. As cross-border investment soars and institutions like the Euroclear system develop services to offer pan-European stock exchange settlement possibilities and more-equity focused custody services, investors will derive similar benefits to those they enjoy in the bond markets. Therefore, equities could well be the next hottest ticket for lenders.
Pedro Pena Taveria is product manager, Euroclear securities lending and borrowing program