ETFs & Securities Lending - Perfect Partners?
The practice of securities lending is evolving across regions, with ETFs in particular playing an increasingly important role as a source of securities to lend. This article, written by the Irish Funds ETF Working Group, examines some of the market and regulatory factors, including changes in collateral profile, which are driving these changes, and the developing trend of lending of ETF shares themselves.
On the face of it ETFs and Securities Lending is a marriage made in heaven: ETFs offer a portfolio of securities which passively track an index, the additional income generated via securities lending can help reduce tracking error and boost fund performance and the ETF itself is lendable and can also possibly be used as collateral.
From a borrower’s perspective lenders of ETF inventory offer a stable portfolio of securities which are unlikely to be recalled even where corporate events occur due to the ETFs obligation to track an index. This makes ETF inventory more attractive to borrowers anxious to guard against the recall of “specials”.
At the end of last year, globally, securities on loan were in the region of €1.7 trillion. Of this, 50% was equities, 48% fixed income securities and 2% ETFs though this does vary by region with the figure of ETFs on loan higher in the US than in Europe.
The dynamic of the market is changing driven by a number of trends such as changes in economic policy where Central Banks are under pressure to put securities back on the market as a result of various quantitative easing programmes. Central Banks are now supplying at least 13% of the securities on loan in the global market. This is a trend likely to continue as a result of the vast inventory of securities now held by Central Banks.
Another trend driving the market is the change in the profile of collateral driven by change in regulation. Cash collateral is going out of fashion. 60% of the securities on loan are now collateralised with securities rather than cash, up from 40% 5 years ago. 90% of European government bond securities lending transactions are collateralised with securities rather than cash. Increased demand for eligible collateral is likely to further drive demand for borrowing government bonds. Indeed, ETFs themselves may soon become more acceptable for use as collateral; this is not a regulatory restriction currently but more an education process.
Term lending is also becoming more popular with 15% of the securities lent being on terms of 3 months or more. Again, given the stable nature of ETF portfolios, this should make ETFs a good match for borrowers seeking term lending.
Why would an ETF Lend?
“Risk free return”
In today’s market very low risk returns are rare. A fund’s board must weigh the incremental return generated by securities lending against the risks inherent in lending the fund’s portfolio. Through lending its securities, an ETF can use the revenue to offset the costs of managing the fund, thus reducing the tracking error. In a market where low fees are key to driving asset growth, lending the fund’s assets is a controllable risk to generate additional basis points.
While the benefits of lending the underlying securities of an ETF are apparent, what about lending of the ETF itself? In Europe several large ETF providers are working to educate the financial community as to the benefits of lending the ETF shares themselves. Some global asset managers have been involved in lending ETFs in the US for almost a decade but until recently did not see the commercial opportunity in Europe, but this has started to change in the last 12 months.
Challenges to the growth of the European Market
How does the US experience compare to the Europe?
The asset class is developing in Europe as borrowers are seeing bigger, broader and deeper inventory. Borrowing ETF shares allows them to be used as a macro hedge for a number of different purposes, particularly for Fixed Income investors who use them as a better proxy to CDX. For equity investors, increased cost in trading futures is also driving investors to consider using ETFs for the first time.
Lending of ETF shares is still massively skewed to the US which represents 90% of online balances, mostly driven by prime brokers and hedge fund clients. Borrowers are still more comfortable with liquidity in the US though this is starting to change as the depth of supply is improving in Europe and the opportunity to facilitate shorting is improving.
A cultural change is needed in Europe to develop this asset class, led by an education process and an improvement in pricing transparency. While regulation can help here, technology solutions are required to help print trades within a shortened time frame.
Transparency in the depth of liquidity in the European market is lacking and there is no transparency in the OTC market. That said, if the US example is to be followed we may see a hockey stick style growth in the European market.
Although the US market is significantly ahead of Europe to date, it is characterised by some structural inefficiencies. The sell side is sometimes considered to have “eaten the lender’s lunch” and dominated supply through “create to lend” which is arguably controlled by only a handful of investment banks in the US. However, as increased capital charges apply to the lending business this opens up opportunities for Agent Lenders to take ground from retreating banks in the lending of ETFs both in the US and in Europe.
What more could be done?
Ahead of MiFID 2 market participants could voluntarily print trades which would show more liquidity in the European market. At present US macro funds prefer to trade futures and US domiciled ETFs as there is greater transparency, and hence perceived liquidity in those securities than in European equivalent ETFs.
Were CCPs to accept ETFs as collateral this would increase the demand for borrowing of ETF shares. ICE, CME and EUREX are now accepting ETFs as collateral. S&P ETFs are now larger in AUM and more liquid than the entire US Futures market and the cost of holding these exposures via ETFs at approximately 10 basis points is less than the cost of rolling S&P futures which has risen from historical costs of around 10 basis points to 30 basis points over the last 12 months.
Structural Inefficiencies in the European Market
At present, settlement is fragmented across Europe. For example, an ETF listed on the London Stock Exchange or Irish Stock Exchange will settle in CREST, however, it may also be listed and traded on a number of other European exchanges where shareholders want delivery via their domestic central securities depositary (CSD). An Authorised Participant may need to borrow ETF shares to facilitate settlement in a domestic CSD while they move shares between CREST and the local CSD for settlement. This multiple CSD model results in shallow and fragmented pools of liquidity.
The relatively new ICSD settlement model introduced by Euroclear in Europe in late 2014, creates a single settlement venue for the settlement of trades across a number of markets. An advantage of this settlement model is the creation of a single liquidity pool and less settlement risk which ultimately should reduce the spread on European ETFs using this settlement model. In the US where ETFs settle via DTCC, ETFs make up 30% of the cash equity market, whereas in Europe ETFs only make up 10% of the on-Exchange market.
Interest in shorting European ETFs is much lower than is the case in the US to date, due to a lack of visibility on supply and the structural challenges outlined above. It has been very much focused around the larger names. To a certain extent there is a virtuous circle between large funds and lending. There are a higher number of smaller funds in Europe (2,320 European ETPs v 1,777 in US) which again leads to fragmentation. The costs for a market maker of borrowing shares are higher currently than the costs of creating shares so this may spur the growth of a create to lend market.
With the changes to capital and collateral requirements, regulation is driving changes in favour of ETFs as derivatives become more expensive to trade for short exposure.
ETFs are a liquid investment vehicle.
Increased transparency on the liquidity in the market will drive lending - there is a chicken and egg relationship between the two currently.
The use of ETFs as collateral should also drive growth in the ETF market, and hence drive further use as collateral.
By devising a uniform and industry-wide identification process and grouping similar ETFs in a simple and transparent “index”, Markit have helped eliminate the “heavy lifting” that risk officers often didn’t have the bandwidth to perform. This should also further the advance of ETFs as collateral on a global stage.
Increased market unification in Europe for settlement periods and between CSDs will result in greater liquidity and more efficient settlement thus creating an environment for greater lending of ETF shares. Ireland, as the leading ETF domicile in Europe by a significant margin, is well-placed to benefit from the market efficiencies and overall growth.
Antonette Kleiser | Vice President | European ETF Product, Investor Services, Brown Brothers Harriman Trustee Services (Ireland) Limited
Des Fullam, Director, Carne Group