How securities lending and borrowing can boost EU capital markets

Key Takeaways

• EC is reinvigorating the push for a Capital Markets Union
• Fragmented markets are hampering efforts to meet green targets
• Facilitating securities lending and borrowing is critical to success

The European Commission’s (EC) efforts to establish a Capital Markets Union (CMU) have been hampered by notoriously slow bureaucracy and a series of political, economic, and health events, including the COVID-19 pandemic and the war in Ukraine.

Despite this, there is still motivation to get the job done, not least if the European Union (EU) is to secure funding for ambitious green and digitalization transitions, which are estimated to require an additional EUR 620 billion and EUR 125 billion, respectively, every year.

Speaking in November 2023, Christine Lagarde, president of the European Central Bank, was clear that should the EU fail to unite its capital markets, it will fail to protect member states from the impacts of climate change, deglobalization, and an ever-increasing aging population.

“Despite two European Commission action plans, Europe’s capital market remains fragmented. Financial integration is lower than before the financial crisis,” she said. “We will not succeed in these transitions if we don’t get the CMU back on track.”

Trillions in untapped potential

Among the many organizations keen to see progress on the CMU is the International Securities Lending Association (ISLA), which argues that securities lending and borrowing (SLB) holds the key to unlocking the market liquidity that will support the EC’s CMU plans.

Describing SLB as “one of the most efficient mechanisms to facilitate the flow of securities between supply and demand”, ISLA notes the “significant untapped potential of securities supply held in portfolios of EU-based lenders” and says that UCITS (a type of investment fund regulated by the EU), pension funds, and insurance companies are underutilized.

ISLA finds that UCITS hold approximately EUR 8.4 trillion in assets, of which EUR 2.5 trillion (27%) are available for loan; yet only EUR 194 billion (7.8%) are used as such. Meanwhile, pension fund assets have loaned out EUR 32 billion of the EUR 3.37 trillion available, which equates to just 6.1%.

“If fully mobilized, SLB can be a key tool to unlock capital, enhance market liquidity, and support investment across the EU – the foundations for competitive capital markets,” ISLA argues.

Sharpening regulatory focus

ISLA calls on the EC to focus on four key themes: securing and expanding supply-side channels; optimizing and enhancing demand-side channels; advancing EU infrastructure to drive forward market efficiency and digitization; and improving the financial stability data reporting framework for SLB to ensure market resiliency.

Regulatory reform will be essential for SLB to flourish in the EU. A 2024 paper from the Journal of Financial Regulation finds that European regulators’ efforts to bolster the securitization market have had the opposite effect.

“Not only has the 2019 Securitization Regulation (SECR) and its amendments failed so far… but they also seem to be functioning as an effective roadblock to securitization by creating even greater distortions than their predecessors.”

ISLA warns that any future legislation should be in the form of regulations rather than directives, “to improve consistency of implementation and interpretation, and agility in making changes”.

Getting the balance right

The trade association is also keen to avoid applying an unnecessary regulatory burden on securities lending that would ultimately undermine the benefits of improved financial stability and risk mitigation.

It points to the Securities Financing Transactions Regulation (SFTR), which aims to increase transparency and reduce financial risk in the securities finance markets.

The SFTR is currently under consultation, which ISLA welcomes, focusing on good practice in governance arrangements, such as on the role, operation, and effectiveness of the management bodies of the entities supervised by the European Securities and Markets Association (ESMA). The proposed guidance is also aimed at future supervised entities.

Clearer definitions of the key terms that are core to securities lending and borrowing activity must also accompany regulatory reform, according to ISLA.

Sustainable matters

In particular, the association says “the absence of clearly defined sustainability legislation targeting investment tools such as securities lending” hampers SLB’s positive contribution to sustainable investment. This void sees institutional and retail investors take a “stricter approach to engagement in the activity, which could ultimately hinder growth in EU markets, as well as hinder liquidity in sustainable securities”.

The challenge comes from the transfer of shareholder voting rights from the lender to the borrower. Pension funds typically have responsible investment strategies in place that require the active corporate governance of their investee companies. The risk is that borrowers do not share the long-term horizons of lenders, which in turn facilitates short-term profit-generating behavior from corporates at the expense of sustainable, responsible practices.

Neither the EU nor UK regulators have found any evidence of a link between SLB and declining standards of corporate governance. However, in post-Brexit UK in 2022, the Financial Conduct Authority called on lenders to “clarify securities-lending policy and the steps [they take] to ensure this is coherent with the sustainable investment strategy.”

More investors, more protection

ISLA is also keen to see retail investors play a bigger role in the SLB market through online platforms.

However, in 2023, the European Securities and Markets Association made clear that securities lending is a “risky and complex practice that is difficult to understand for the average retail client”.

In response, ISLA says investor protection efforts should include “raising awareness and transparency about the benefits/risks of securities lending.” But the reality is that retail investors will certainly need greater protection than their sophisticated institutional counterparts.

Concerted efforts and technology

If ever there was a need for a CMU it is now, and the EC will welcome ISLA’s support as it pushes for capital markets harmonization.

However, past attempts to implement the CMU have not been wholly successful, and the EU needs a concerted effort from all interested stakeholders to achieve its transition plans.

In the meantime, firms across the bloc (and the UK) must overcome the operating difficulties arising from disparate compliance regimes as efficiently as possible. Technology should play a major role. Cost pressures, market uncertainty, and evolving regulations have increased the need to simplify and automate workflows. Risk will not disappear, but secured funding desks that have a holistic, real-time view of risks will be in a better position to manage them.