ETFs in securities finance -Exploiting the opportunity
As part of the Euroclear Collateral Conference 2016 held in Brussels in November, a panel of industry experts discussed the role of ETFs in securities lending and collateral management. All agreed there were untapped opportunities for growth.
By way of context, the moderator, Grant Davies of CORE Collateral, highlighted the ‘exponential’ growth enjoyed by Europe’s ETF industry since 2009, with assets under management trebling over the period to around USD 150 billion. A significant part of that growth has come in 2016. Spurred by strong demand for fixed income, ETF providers have gathered around USD 30 billion of new assets over the year to date.
“That very much mirrors the way the US products have grown and become a trading product of choice,“ said Davies. One contrast, however, is that in Europe ETFs still play a relatively minor role in securities finance. The question for the panel was what it will take to change that. Three themes emerged.
Changing market infrastructure
A number of speakers drew attention to the role a centralised market infrastructure has played in the US in encouraging both lending of ETFs and their deployment as collateral – and the potential for the European industry in moving to similar centralisation through the ICSD model pioneered by Euroclear.
European providers have traditionally crosslisted products to access domestic markets and settled them in domestic CSDs.
By contrast, the centralisation inherent in the new ICSD model in Europe makes it much easier to run a lending programme, said Mark Harris of State Street Global, one of two ETF providers on the panel:
”It removes a lot of the frictional costs and the fragmentation we see in the domestic structure. You also have a single ISIN rather than the multiple SEDOLs which make locating shares very difficult. Overall, the ICSD model is a real catalyst for change”.
That was echoed by Citibank’s Gareth Mitchell on behalf of the agency lending community. Citi, he explained, had historically broken down its USD 2 trillion of lendable assets into fixed income and equity – and ETFs were always classified among the latter, even where they were fixed income-related. The issue of multiple locations and multiple ISINs or SEDOLs was a deterrent to effective lending.
”So the move to an ICSD has started to concentrate some of that liquidity into a place that is identifiable”, he said. “We are working internally to reclassify ETFs into a separate asset class – in fact two asset classes, one
equity-driven, one fixed income-driven. The move has certainly helped. Availability is going up and the loan balance is going up – with peaks and troughs depending on what is going on in the market.”
Progress still depends, he said, on clients moving their holdings out of the local CSD – in many cases CREST.
”We’ve still got work to do to encourage clients to move their assets to Euroclear. I hope this can be done by demonstrating the value they are missing by keeping the securities in their local depositary rather than a central one.”
Jacco Verpoorte, an ETF trader with Flow Traders, agreed the traditional model is holding the industry back: ”After a trade I look at my book and see where I have the shares. For example, I may hold them in Italy but I need them in Switzerland. That requires a realignment which involves cost, takes time, and something could go wrong. The US market has none of those issues – nor does the new international model in Europe, which is one of its main benefits.”
The proliferation of different types of ETF – physical, synthetic, inverse, leveraged – has complicated the process of classifying them, which in turn can make it difficult to incorporate them in a collateral schedule.
Matthew Fowles, of ETF provider iShares, said the classification issue has meant that anyone accepting ETFs as collateral has historically
been obliged to verify each one line by line: “That is very inefficient and very timeconsuming,” he said.
Now that is changing. In a key development, IHS Markit has launched listings of ETFs that are filtered by a number of eligibility criteria,
including asset class and benchmark, leverage, geographic exposure and assets under management. It publishes them on a daily basis.
“Now triparty agents can feed this information into their collateral schedules and accept ETFs without having to prove every line,” said Fowles.
The IHS Markit lists span more than 6,000 ETFs. “Hopefully, we will get to the point where 80% are covered in a series of lists,” said Fowles. “There will always be a frictional amount around the edges but we are hoping that agent lenders will look at these lists and accept them.”
Neil Nicholls of ABN Amro Clearing Bank, a prime clearer, said the IHS Markit lists had certainly improved the acceptability of ETFs as collateral. “We are starting to see some traction in being able to utilise our long positions in ETFs and for us that has positive balance sheet implications. To be liquidity-neutral is a big plus and will help to bring down fees. Anything we can do to reduce the fees to our market maker clients makes us more competitive.”
A number of panellists remarked that lending and collateralisation of ETFs continue to be held back by perception problems. One of the big challenges is to get risk departments to understand precisely what ETFs entail.
“There has been an education process ongoing within the risk departments of the banks and prime brokers, certainly in the equity space, for
the past 12 to 18 months,” said Nicholls. “As a result, collateral is becoming easier, availability is improving and haircuts are starting to move.”
It is apparent that many in the market have yet to understand there is financing demand. Fowles commented that there is a lot of market maker
activity that creates financing demand. “We are certainly making people aware the demand is there and that they should consider ETFs. If you
are prepared to take the underlying, you should at least consider the wrapper.”
Historically, much of the borrower demand has been fails-related and inevitably short-term. Several panellists suggested this is beginning to change, which should be positive for fees.
“This is quite important for the lenders,” said Nicholls. “They have previously seen ETF lending as a two or three day trade where they are not going to get a real fee. As a result, fees have been expensive. But they are not expensive relative to a longer-term strategy.”
Mitchell agreed: “As a lender you are trying to absorb the cost of the trade in a very short term. The agent lender takes only a percentage of the fee but pays all the cost. A one or two-day trade has to be at 2% to even start breaking even.”
One other shift in the market is relevant here. ETF financing has historically been managed by equity finance desks. With the growth of fixed income products, more fixed income desks are getting involved.
Harris stressed the importance of this: “It means more repo traders will be looking at them – considering them for shorts, or financing longs.”
All panellists agreed that momentum is building behind the deployment of ETFs as financing tools. Both demand and availability are increasing at a rapid rate, thanks in no small measure to centralisation within Euroclear and IHS Markit’s classification listings.
“I would encourage beneficial owners to put their assets in that single depositary,” said Harris. “There are so many benefits.”