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Wealth Management and Financing
Environmental, Social, and Governance Factors in Securities Lending
Investment professionals see increasing demands from their clients for consideration of environmental, social, and governance (ESG) factors in finance and wealth management decisions. At first glance, securities lending transactions might seem to be distant from the direct impact that an investor can have on an investment target’s ESG policies. Nonetheless, the securities assets that investors place into a lending environment and the lender’s and custodian’s management of that environment can have a significant ESG impact.
Recognizing this, the Pas Asia Securities Lending Association recently announced guidelines for an initiative called the Global Framework for ESG and Securities Lending GFESL). These guidelines lay out a best approach that beneficial owners of securities can adopt when they incorporate securities lending and stock loans into their greater wealth management strategies. When investors are evaluating whether to enter into a securities lending transactions, the guidelines encourage them to consider voting rights, transparency in the borrowing and lending transaction, collateral and cash reinvestment, lending transactions that span the record date of the underlying collateral, short sales, and rehypothecation of the collateral at the end of a lending period.
As to voting rights, the guidelines encourage investors to anticipate if or when votes on significant corporate matters will be put in front of shareholders and to factor control of voting rights into decisions as to which securities to use as collateral in a securities lending transaction. Lenders in collateralized stock loan transactions may be able to accommodate an investor’s desire to vote on ESG issues with different contractual provisions that address which party controls voting rights in the securities that are used as collateral in a transaction.
Increased transparency in a securities lending transaction might reflect an enhanced ESG framework. Although lenders will generally not impose use-of-funds restrictions on loan principal balances, borrowers that have an ESG focus reinvest liquid cash that they receive in a stock loan transaction for more sustained ESG purposes.
Any stock loan transaction with a term of more than one year will likely cover the record date of the securities comprising the collateral. Investors who are focusing on ESG issues will need to place greater consideration on voting rights and their opportunity to exercise voting control over the collateral when they evaluate the pluses and minuses of a securities lending transaction.
Excessive short sales activity in any security may be a warning sign of weak management. Short selling already improves efficiency in share pricing and overall liquidity in the market for the underlying securities. Investors can structure securities lending transactions to increase short interest in a particular stock and to send signals to management without ceding total control or fully liquidating their positions in that stock. The same philosophy holds for rehypothecation and unwinding of securities lending transactions at the end of a loan term.
Overall, the ability of both borrowers and lenders to use stock loans and securities lending as a tool to focus an issuer’s attention on ESG factors will continue to grow as more investors come to understand their ability to affect management decisions that might have an ESG impact. Securities lending can therefore be much more than a tool for investors to realize the cash liquidity of their securities assets without selling them. In this sense, an informed investor can use stock loan transactions as a fully functional tool in a well-devised wealth management strategy to accomplish ESG goals and strategies.
Wealth Management and Financing
The Growth of Securities Lending Opportunities in the Private Sector
Traditional securities lending transactions originated within the limited universe of large investment banks that developed mechanisms to derive new revenue streams from their inventories of publicly traded securities. Direct lenders subsequently opened the industry to private investors through collateralized stock loans and related transactions that gave those investors to use the cash liquidity that had previously been locked into their portfolios. A recent partnership between Citi Ventures and the financial technology firm, Sharegain, has created additional opportunities for wealth management firms to participate in the industry.
In traditional securities lending, the holder of a large block of stock lends that stock to a borrower entity. The borrower delivers cash collateral to the lender and uses the stock to cover short positions and for other purposes until the transaction is unwound. Direct finance entities built on this model to create the collateralized stock loan industry, in which a private investor uses securities as collateral for a nonrecourse loan. Nonrecourse collateralized stock loans remove many of the multi-party complexities in traditional securities lending and, accordingly, are a more suitable investment strategy for private individuals.
The Citi Ventures partnership is a step toward bridging the gap between these two ends of the industry. It utilizes existing technology infrastructure to give wealth managers the opportunity to select stocks that they want to put into a lending environment and to review lending terms and conditions that might apply to those stocks. This is essentially the same protocol that had only been available to large institutions that have the size and scale to derive significant profits from securities lending. With the new partnership, smaller wealth management firms and other financial advisors would now have the same opportunity.
Citi Ventures expects to roll out this new opportunity on a limited basis in certain markets in Asia. The securities lending industry and its service providers have already established a strong foothold in most Asian countries. Citi Ventures’s choice to open its new offering in the Asian markets is likely a reflection of an already-strong foundation and the growing demand from investors in those markets for financial products and services that had previously been confined to the institutional market and the parallel growth of new investments and entrepreneurial corporate activity in those markets.
The technology partner, Sharegain, has stated that its collaboration with Citi Ventures reflects a potential to democratise securities lending. Sharegain previously launched a platform to support environmental, social, and corporate governance (ESG) factors by enabling investors to allocate a percentage of their lending liquidity to ESG initiatives.
Perhaps the most telling element of the Citi Ventures-Sharegain partnership is that the products and services are targeting wealth management firms. Many of those firms might have previously guided their clients away from securities lending and stock loans. The expansion of securities lending to include wealth managers is a reflection of how the industry has matured and become a mainstream component of more progressive wealth management strategies. Innovative investors will continue to look for opportunities to derive value from their portfolios, and the growth of securities lending opportunities in the private sector will continue to serve that desire.
Wealth Management and Financing
Securities Lending and the Digitisation of Securities Assets
The traditional securities industry developed first around physical certificates that represented the number of shares owned by an investor. Those physical assets gave way to electronic certificates that simplified and expedited the clearing of trades and other securities transactions. The industry is now poised to move into digitized assets supported by new market infrastructures and rules and regulations that will further enhance transaction flow while providing investors with assurances that their investments are safe, fully trackable, and protected.
A digital asset security is a product that has been issued and that can be transferred via distributed ledger or blockchain technology. Most investors are familiar with digitized utility tokens, such as the Bitcoin or Ethereum cryptocurrencies that are interchangeable with liquid cash. Digital asset securities rely on similar technology but are referred to as security tokens. Like physical or electronic certificates, security tokens represent an ownership stake in a publicly traded company and entitle a holder to a share in the company's declared profits.
Government agencies, including the United States Securities and Exchange Commission and other international securities authorities, likely have the same regulatory authority over securities tokens as they do over physical and electronic securities, although there is an open question over whether the definitions in the agencies’ regulatory framework is broad enough to encompass securities tokens. Major international investment and commercial banks, including State Street and BNY Mellon, have formed internal units to build on their digital asset security presence in the securities markets. Given this push from the private sector, it is likely that the regulatory sector will soon amend its structures to verify coverage of securities tokens.
The challenge to the securities lending and finance sector of the industry will be to develop strong collateral management and central depository systems that address investor risk in securities borrowing and lending transactions. Virtually every stock loan transaction is currently conducted with non-physical certificates that are transferred electronically into custodian accounts. Unlike physical certificates, securities that are in an electronic format do not have a defined geographic location but are instead represented by entries in a custodial account. Digitised securities tokens are further removed from a presence at a single physical location. Regulators and industry insiders are developing mechanisms to make transactions more transparent to give investors a clearer picture of how their loaned or borrowed digitized securities assets are being managed.
The primary advantages of using digitized securities tokens in a securities lending transaction are the speed and efficiency that will characterize the transaction. Even with electronic certificates, one to three business days might elapse before the transfer of electronic collateral is cleared and acknowledged. Digitised securities tokens have the potential to introduce real-time transfers that will expedite the delivery-versus-payment aspect of a loan transaction. Theoretically, an investor will be able to see transaction proceeds in his or her account almost simultaneously with the transfer of a digitized security token, rather than waiting 24 or more hours as may currently be the case.
Some industry observers see a full transition to digitized securities assets occurring over three phases. First, all non-digital assets, including securities that are represented by physical certificates, will be transitioned to electronic certificates or directly to securities tokens. Second, industry participants will adapt their systems to reflect hybrid transactions that involve both electronic certificates and digitized tokens. Last, securities assets will be fully digitized with full implementation of industry structures that are designed to manage digitized securities tokens.
Some analysts see this process playing out over the next 15 to 20 years. The entities that facilitate securities lending and related transactions have already begun the transition to this new regime and will continue to lead the charge as securities tokens become the norm to represent collateral in the stock lending industry.
Wealth Management and Financing
Proposal to Expand Reporting on Short Sales
In the early days of the COVID-19 pandemic, international securities markets experienced significant economic dislocations and erosion in share pricing. Some investors took advantage of those markets by increasing their short sale positions, which led market regulators in several countries to impose restrictions on short sales activities. Early data now suggests that securities markets in countries that did not impose onerous restrictions fared much better in terms of share price stability and liquidity, which supports the theory that short sales facilitate a more efficient market for all investors.
Intelligent short sale disclosure and regulation are the keys to maintaining market efficiency in uncertain markets. Because of this, the Financial Industry Regulatory Authority (FINRA), which has the authority to license and regulate broker-dealers in the U.S. securities markets, recently proposed amendments to short sale reporting requirements for its members in the U.S. markets. If adopted and implemented, those amendments will have a positive impact on the securities lending industry, which, in part, supports short sale activity by enabling investors to borrow shares to cover short positions.
FINRA has specifically proposed to consolidate the publication of short interest data for both listed and unlisted securities and to make that data fully transparent and freely available on its website. Currently, FINRA treats OTC equities transactions and exchange-listed securities differently. FINRA’s proposed amendment implicitly recognizes the growing number of unlisted securities that are traded on electronic markets.
Another of FINRA’s proposed amendments would require securities trading firms and investment banks to report their synthetic short positions. Synthetic shorts are options strategies that investment managers use to simulate the payoff of a short stock position. In theory, the strategy offers unlimited profit potential, but that potential is offset by unlimited risk. FINRA’s proposal to include this data in short sale reports indicates the growing popularity of the strategy.
From a broader perspective, FINRA’s inclusion of synthetic short sale data, which is an options and not a direct short sale strategy, reflects the Authority's focus on full disclosure of all share sale interests and information on total shares outstanding and the public float. Even if FINRA had been focusing on the disclosure of this information for some time, the pandemic drove home the importance of full disclosure of all short interest data and likely prompted FINRA to include this disclosure obligation in its proposed amendments.
The proposed amendments will likely have little or no immediate impact on the stock loan and securities lending industry. FINRA has jurisdiction over activities in the United States. It remains to be seen if other jurisdictions will adopt similar disclosure requirements. If data from the early days of the COVID-19 pandemic remains consistent, that data may compel other jurisdictions to pursue that path and to offer greater support to short sale activity and strategies.
Even if they do not actively use collateral shares in a short sale environment, securities lending and stock loan institutions have a vested interest in that environment. Share liquidity is a critical component for a robust stock loan offer. Collateral stock that exhibits a stronger trading pattern will always support terms and conditions that are more favorable to an investor, including lower interest rates and higher loan-to-value ratios. Investors that incorporate securities lending and stock loans as a component of a complete wealth management strategy would do well to support the adoption of regulations that increase transparency and disclosure of short sale data in the markets in which they participate.
Wealth Management and Financing
Succeeding As A Small State In A Large International Economy: Focus On Singapore:
More than US$750 billion worth of trade passes through Singapore every year. The island-state sits at a geographically precarious outpost with Malaysia and China to its north and Indonesia to its south yet boasts one of the richest economies in southeast Asia that is bolstered by political stability and respect for the rule of law. The COVID-19 epidemic has raised a question of whether and to what extent this small state will survive the economic dislocations brought on to the international economy by the COVID-19 epidemic.
Singapore’s history provides an answer to this question. The British Empire founded a colony in Singapore in 1819 and used its strategic location as a trading hub between its other far east colonies and the rest of Europe. Singapore gained its independence in 1965 and rapidly undertook the development necessary to bring it on par with the rest of the industrialized world. The country’s small size made it amenable to a form of government that was largely authoritarian but that recognized individual rights and liberties. That authoritarian government adopted an industrial strategy that attracted foreign direct investment and opened its economy to globalization long before any of its regional neighbors joined the international economy. Simultaneously, the country built housing and supported schools for its citizens, which reduced domestic unrest and made Singapore even more attractive to foreign investment.
For more than 50 years, Singapore’s stability and strong institutions gave foreign investors the assurances they wanted and needed to make long term investments. The country’s manufacturing sector experienced rapid growth that was further fueled by a vibrant shipyard industry. When Singapore manufacturers faced increased competition from enterprises in neighboring Asian countries, the country became even more successful by changing its economic backbone with tax and regulatory incentives that led to the establishment of a thriving financial services sector with international banking, consulting, and insurance services that cater to all of southeast Asia.
Singapore’s willingness and ability to transition from manufacturing to services and its highly qualified workforce and strong education system have enabled Singapore to thrive in a challenging geographic region with potentially hostile neighbors and a dearth of natural resources.
Early in 2020, the World Health Organization declared a global health emergency as the COVID-19 pandemic threw the world’s economy into disarray. Singapore was one of the first countries in its region to implement travel restrictions to prevent a widespread outbreak that would otherwise overwhelm the country’s healthcare resources. Those restrictions brought censure from the Chinese foreign ministry, which blamed developed countries with robust healthcare systems for imposing travel restrictions that adversely affected China.
The economic relationship between China and Singapore is a two-way street. China has been Singapore’s largest trading partner since 2013, and Singapore is China’s largest foreign investor. Singapore relies on the millions of international visitors that come to Singapore every year, including almost 3.5 million from mainland China alone. The average spending by Chinese tourists in Singapore is almost double that of visitors from other countries. Singapore swallowed a bitter pill when it precluded those visitors and their pocketbooks from visiting the island-state.
Singapore authorities were likely aware of the risks and costs of a travel ban when they imposed it. Singapore’s government lost more than US$230 million in response to the 2003 Sars epidemic. In a few short weeks, Singapore has experienced an impact on its economy COVID-19 that has already exceeded the costs imposed by Sars.
Perhaps in recognition of its small size, Singapore has slowly allowed work pass holders who have traveled to China to return to Singapore. Singapore is taking this action presumably because its native population is not large enough to meet the needs of all of its healthcare, transport, and waste management services. Singapore has predicted that its manufacturing sector will suffer as a result of its actions in response to COVID-19 and that its relationship with China may be permanently affected by the travel ban. The country adopted a proactive approach to ease those tensions when it announced an assistance package to China and made donations to international aid organizations that were supporting the Chinese communities most affected by COVID-19.
Singapore’s history and its nimble approach to previous economic stresses bode well for the country’s prospects. Investors that are considering Asian opportunities would be well-advised to keep Singapore at the forefront of their considerations. The strength of Singapore’s economy before the COVID-19 epidemic will put the country and its industrial and financial sectors on good footing to recover quickly when the pandemic comes under better control. The country has long been a conduit of Asian trade and shipping, and there is no reason to suspect that this conduit will be closed down or bypassed as the region comes back online.
Wealth Management and Financing
Searching for Startup Unicorns in a Bear Market
A common feature of both bull and bear markets is the presence of unicorns, namely, those enterprises that are able to absorb the economic circumstances that markets throw at them and that thrive by serving new demands created by those circumstances. Many Silicon Valley investors thought they had identified the startup unicorns in their back yard, but the coronavirus market shock has shown just how rare those unicorns are.
As evidence of the ephemeral nature of a unicorn, consider the San Francisco short-term rental startup, WanderJaunt. This once-high flying company laid off a fourth of its staff after experiencing a slate of cancellations in March 2020. Likewise, Wonderschool, a start-up that connects parents with daycare and preschool providers, recently cut most of its staff after the demand for its services all but evaporated in March. Other startups, including ClassPass, which offers fitness class membership programs, scrambled to create video streaming services to replace the in-person services that they had previously provided.
Real unicorns, if they ever existed, may have gone extinct through the process of natural selection. The natural selection that is killing of Silicon Valley’s corporate unicorns is marching through the region at a blistering pace. The New York Times reports that upwards of 6,000 employees were furloughed from more than 50 startup companies in March. Startups that had attracted significant investor attention at the end of 2019 are now putting. plans for initial public offerings on hold. Newer tech companies are scrambling for a depleting pool of angel investor capital.
The companies that looked like durable unicorns, including Airbnb and other peer-to-peer sharing services, are fighting a two-front war. On one front, they are struggling to maintain their existing business; on the other front, they are fending off ever-present challenges from smaller companies that have a more disruptive mindset. The immediate effect is that the few survivors are suspending hiring or laying off staff and reducing or eliminating marketing budgets.
Some industry sectors might look like fertile ground for unicorns, including telemedicine, food delivery, online learning, remote work, and gaming. Separating the unicorns from the imposters in these sectors, however, will be a challenge to even the most seasoned venture capitalists. Given a few of the much-hyped but underperforming IPOs of 2019 (e.g. Uber, Lyft, WeWork), and in view of the COVID-19 pandemic, Silicon Valley venture capital firms are issuing blanket warnings to start-ups, leaving many of the riskiest start-ups exposed to the sudden termination of capital investments and an almost-certain death of thinly-capitalized enterprises.
Silicon Valley has never been known to accept defeat. Almost as quickly as some startups were closing up shop, others jumped in to take their place and respond to the conditions that drove many erstwhile unicorns away. Furloughed valley employees have rushed to sign up for Upstream and Silver Lining, networking apps that connect tech workers affected by coronavirus layoffs with companies that are still hiring. Hiring manages and recruiters are sharing weekly newsletters like Layoff List, which is published by Drafted, a Silicon Valley recruiting company. Tech veterans in the Valley know that venture investors may have shut off the startup money tap now, but the larger established tech companies are still sitting on piles of cash.
The startup unicorns that will survive the current shakeout are shifting to survival mode, in which they cut spending, lower prices on products, renegotiate fixed costs for things like leases and take advantage of government programs that have been hastily put into place to help small- to midsize businesses and their employees. Successful executives will adopt a “wartime C.E.O.” mentality that will have them doing whatever it takes to win in the face of the existential coronavirus threat. WanderJaunt, for example, may have laid off a fourth of its staff, but it also quickly transitioned from serving the needs of from vacation travelers to helping employees and others displaced by the virus, like stranded college students, people seeking a separate workspace or medical workers isolating themselves from family. In this environment, companies no longer have the luxury of taking days to make major decisions. Those decisions are now made in a matter of hours.
The venture capital that fuels the valley will likely sit back in the short run to let natural selection run its course and to allow struggling startups to fade away. A number of startup unicorns will die, but the relationships that fostered those startups will continue to breed new ideas and opportunities. One small San Francisco-based venture firm, Alpha Bridge Ventures, has committed to contribute $25,000 to founders that it backed for new startups if the founder’s existing company fails due to coronavirus issues. If a once-novel solution is no longer viable, a creative mind will always find something else that is.
Investors that seek to increase the values of their portfolios will need to work harder to find the viable startup unicorns in this market. They will always have the option of waiting for established venture capital firms to reopen their pocketbooks and then to follow that wave of investment, but that strategy may lead to forfeiture of early substantial gains. In every case, investors need to be prepared to leverage their capital resources and to act quickly when they do find an elusive but valuable opportunity.
Wealth Management and Financing
Will China Lead The Worldwide Economic Recovery?
Whether rightly or wrongly, the news cycle has focused on China’s initial and subsequent responses to the coronavirus outbreak in Wuhan province. Financial media outlets have shifted their attention to the global economic consequences of the pandemic, but that focus has largely ignored the renewed stability of China A-shares, which have been quietly outperforming other international market indices without showing excessive fluctuation.
China recovered from the 2008 global financial crisis more quickly than other economies, in no small part due to an RMB 4 trillion stimulus package that the country quickly put into place for infrastructure investment. Government stimulus packages are not a panacea because they are a catalyst for increases in local government debts, cash flow into inefficient enterprises that would not normally qualify for investment capital, and growth in loosely-regulated lending. Regardless, it is beyond question that China’s 2008 stimulus package helped pull China out from a potential downward economic spiral.
Analysts are now watching China to see if an analogous infrastructure stimulus package will be announced. Rapid advances in technology over the past decade have changed the meaning of infrastructure to include not just physical elements such as roads, ports, and railways, but also digital infrastructure, including faster 5G cellular networks, data centers and server farms, and all of the products and services required to develop that digital infrastructure.
The foundation of these digital infrastructure projects is already in place. At least 25 provincial-level regions have put new infrastructure projects in their government work reports. 21 of those regions plan to advance 5G network construction. The coronavirus pandemic appears to have little effect on the rollout of these projects. China Unicom, for example, recently reported that it will finish the construction of 250,000 5G base stations by the end of the third quarter.
Further, China’s consumer space has embraced digitization faster than almost every other major economy. As network providers ramp up their 5G capabilities, China’s cloud computing capacity will increase to better serve big data, self-driving vehicles, artificial intelligence systems, virtual offices, and internet of things (IoT) devices.
China’s imposition of homestay quarantine from late January 2020 has forced Chinese enterprises to rapidly shift to a telecommuting mode, and much of the non-manufacturing work that ended abruptly in January resumed in early February. The mobile apps that were originally developed for China’s white-collar workers, including Alibaba-backed DingTalk, Tencent Conference, and WeChat Work, are adding new in-home education and other functions that extend their utility beyond their white-collar users. Both Alibaba and Tencent added new server capacity to handle traffic that increased by orders of magnitude almost overnight. China’s willingness to invest in digital infrastructure and the transition into remote telecommuting may hold the key to solve the challenges of a coronavirus-induced slowdown in global productivity.
This is not to say that traditional spending on railways, roads, airports and urban utilities will be jettisoned in favor of digital infrastructure. Build-outs of “last mile” logistic facilities, for example, will serve the sectors of the new economy that rely on highly efficient and reliable logistics support.
As China resumes infrastructure work and production, analysts expect to see the country deploy at least RMB 3.5 trillion. That spending will fuel investments and opportunities in related industrial and infrastructure sectors. Chinese administrators will have no option but to adopt more proactive fiscal policies to accelerate infrastructure construction. All of these factors combine to create enormous opportunities for investors to profit from a recovery in China.
An important caveat is that although economists are encouraged by recent rebounds in the Chinese market, they remain divided over whether a recovery will be sharp or more gradual. China reversed course very quickly after the 2003 SARS epidemic, and some analysts predict that any current recovery will mirror China’s experience from 2003. Others look at the February 2020 decline and the subsequent March rebound and emphasize that the reversal is still below certain support thresholds, which could be an indicator of a second decline.
It is rare to find consensus among any group of economists, but the one common thread that runs through virtually every economic report is that no government stimulus will be effective if the global coronavirus pandemic is not first contained and controlled. Containment efforts are ongoing and are showing some early signs of success. The strength and pace of recovery in China and the rest of the world will ultimately be a function of these efforts as much as it will rely on government stimulus and any industrial response to the demands of infrastructure development.
Perhaps the best guidance that any investor can rely on under the current circumstances comes from Warren Buffett, who often tells investors to be greedy when others are fearful. China’s economy has shown remarkable resilience in the past. It continues to have the capacity to serve the front end of a global supply chain for goods and services. Nobody knows when the world economy will recover from the coronavirus shock, but it is safe to say that a recovery will happen. Savvy investors will use this time to take their cash and liquidity when they can and to invest wisely in the enterprises and industries that will be the first to benefit from that recovery.