The start of the decade has presented investors with a tale of two scenarios. On the one hand, escalating geopolitical tensions in the Middle East have ramped up market anxiety. On the other, potential trade resolutions between the US and China, as well as another Brexit deadline that — if both sides can agree — could mean an end to an extended period of uncertainty which has weighed upon investor conviction. This balance of optimism and pessimism couldn’t be more delicately poised.
The securities lending industry has entered an equally active period. The regulatory agenda continues to reverberate with the Securities Financing Transaction Regulation (SFTR) and the Central Securities Depository Regulation (CSDR) shaping market activity. Environmental, social, and governance (ESG) continues to gain attention as the industry looks to incorporate these principles with its broader agenda. Separately, technology will play an increasing role in securities lending programs and will ultimately drive the client experience in terms of transparency, control, and performance.
With regulatory uncertainty behind us and the macro factors outside of the industry shaping up to present both opportunities and challenges, the industry will likely focus once more on growth and innovation.
2019: A year in review
After a buoyant 2018, a year in which the industry saw one of the best returns since the 2008 financial crisis, securities lending demand in 2019 faced several headwinds. Chief among these were geopolitical risks such as Brexit, social unrest in Hong Kong, escalating tensions in the Middle East, and the ongoing US/China trade war. This, in turn, negatively impacted borrowing demand. Global revenue returned approximately $10.1 billion in 2019, representing a year-over-year decline of 6.3 percent.1 While specials activity was strong in North America, in part due to increased IPO activity in the US and robust demand in the Canadian cannabis sector, Asia and Europe both saw broad declines.
In North America, revenue from specials activity accounted for 31 percent of all securities lending activity in 2019, up from 25 percent in 2018.2 Early in the year, two large deals represented the bulk of the activity. Dell Technologies repurchased its tracking shares and pharmaceutical giant Eli Lilly spun off their holdings of Elanco at a discount. These deals, coupled with continued directional interest in the Canadian cannabis sector, were primary drivers for demand.
Just prior to mid-year, directional demand picked up as a flurry of high-profile IPOs came to market – Beyond Meat, Lyft, and Uber, to name a few. Demand for these new share issuances was robust and built momentum in the market that carried through the summer months into Q4, only to recede after lock-up periods expired for these securities.
In Asia, corporate deal activity was generally subdued compared to the previous year, which in turn had a negative impact on revenue, which declined by 8.7 percent year-over-year.3 However, there were several high-profile IPOs in the last quarter of 2019 — most notably Alibaba and Budweiser’s listings in Hong Kong — which helped boost demand, albeit briefly. Despite a broad reduction in deal activity, we did witness continued directional interest in several companies in the Chinese automobile, e-commerce, and technology sectors, such as BYD, Meituan Dianping, and Xiaomi Corp. In South Korea, demand was softer than in previous years, but there was robust interest in the biotech and pharmaceutical sectors, led by HLB and Sillajen, spurred by investor concerns that these sectors continue to be overvalued. Finally, in Japan, lending demand was largely driven by directional demand in specific companies in chemicals, liquid display manufacturers, and robotics where Cyberdyne Inc. was a standout performer.
In Europe, revenue declined by 20 percent year-over-year,4 but demand for specials increased on the heels of significant IPO activity and private equity takeovers in Germany. There was robust interest in Osram Licht, a multi-national lighting manufacturer, after numerous failed potential takeover bids. Demand for Wirecard AG increased after numerous reports of accounting irregularities were published by the Financial Times, resulting in an unprecedented short selling ban. In the UK, there was strong securities lending demand for Sirius Minerals after the miner announced a convertible bond sale following a failure to secure the funding required to continue operations as planned. In France, Casino Guichard, and its parent, Rallye, saw increased securities lending demand as the supermarket group looked to reduce debt by selling stores.
Separately, fixed income returns also lagged year-over-year with the supply of government bonds catching up with the demand for Hiqh Quality Liquid Assets (HQLA). There was also a reduction in the spread between the traditional USD/JPY pair trade, a common driver of treasury demand, as well as pan European government yields reducing throughout 2019. US government bond lending revenues fell by 20 percent year-over-year, with international government bond revenues falling 21 percent.
In the corporate lending space, a reduction in US interest rates saw a strong performance in the credit markets for 2019 and that, coupled with an increase in lending supply and lack of conviction from hedge funds, meant revenue was down by 17 percent from the highs of 2018. There were, however, some bright spots in 2019, with the energy and pharmaceutical related issuers providing significant lending returns. Balances were flat year-on-year, meaning much of the reduction in revenue was due to the suppression of lending fees, leading to a total revenue of $604 million for the year. It is worth noting that although a reduction from last year, 2019 returns were the third highest we have seen in the space behind the highs of 2018 and 2017.
Hedge fund performance in 2019 was rather mixed with performance varying across regions and strategies, which in turn impacted demand. Although hedge funds delivered their strongest returns since 2009 with a return of 10.4 percent for the HFRI Fund Weighted Composite Index, this lagged against the 29.1 percent gain for the S&P 500.5 As of October 2019, long-short equity funds saw redemptions of almost half of the approximately $88 billion that was redeemed during the year while quant strategies saw mixed returns.6 The bright spots have been in some Asian focused and event-driven funds which saw inflows in 2019.