Sovereign Institutions See Securities Lending as Opportunity to Boost Returns and Add Liquidity to Financial Markets

Sovereign institutions are considering expanding their commitment to securities lending to increase returns and to help alleviate what they perceive as a threat to liquidity in the financial markets, according to a survey from BNY Mellon and the Official Monetary and Financial Institutions Forum (OMFIF).

The findings were reported in Mastering Flows, Strengthening Markets: How sovereign institutions can enhance global liquidity, which was based on a survey by BNY Mellon and OMFIF of two dozen sovereign institutions with combined assets under management greater than $4.7 trillion.

“Global liquidity has been strained since the financial crisis, driven by market disruption, regulation and policy action,” said Hani Kablawi, BNY Mellon’s Head of Investment Services for Europe, the Middle East and Africa (EMEA). “Besides seeing this as an opportunity to grow returns and reduce costs, sovereigns see themselves as having the ability to mitigate some of the threat to global liquidity that market participants are facing.”

Seventy-five percent of the respondents indicated they are willing to allocate 10 to 15 percent of their balance sheets for securities lending activities, with some respondents reporting they are considering using 60 percent of their assets.

Seventy percent of the respondents said they expect an additional return of five to eight basis points from these activities.

“Increasing sovereign fund participation in securities lending activities would benefit the financial markets by enhancing the liquidity in a wide range of assets. Doing so could compensate somewhat for the reduction in market-making activities by banks and broker-dealers,” said Brian Ruane, BNY Mellon executive vice president and chief executive officer of the company’s Broker-Dealer Services business. Ruane went on to say that traditional suppliers of liquidity have reduced their activities as a result of increased regulations and central bank policies.

The report notes that regulations such as Basel III implemented after the financial crisis have raised the cost of balance-sheet intensive activities such as securities lending for banks and dealers, leading to greater risk aversion. It also points to actions taken by central banks that have contributed to lower liquidity such as highly accommodative monetary policy, low interest rates and asset purchase programs.

Ruane said, “The bond buying programs have removed just the type of safe assets that are in high demand, while the demand for these assets has increased significantly. Even though liquidity appears to be sufficient today, that could change if central banks become more restrictive. We have already seen the sensitivity of markets to indications that the U.S. Federal Reserve might tighten monetary policy.”

Sovereigns seeking to increase their capital markets roles need to become more connected with key market participants such as custody banks, central clearing counterparties, and tri-party repo providers, according to the report. The report notes that such actions will help the sovereigns overcome challenges regarding counterparty risk, credit risk, collateral risk and cash collateral reinvestment.