Securities lending: The next frontier for ETFs
The ETF market in Europe passed a significant milestone in April 2015 when assets under management exceeded US$506 billion, according to ETFGI. In fact, net new assets gathered in Europe during 2015 are reported to be US$82.0 billion.
This represents a meteoric rise for a sector that began only fifteen years ago and its role in securities lending now looks set to catch up.
While the European market by assets under management is already approximately one-quarter the size of the US market, a 2015 Securities Lending Times (SLT) Markit survey - ETFs as Collateral - notes that less than five percent of ETFs in Europe are used for lending compared with an estimated 25-30 percent in the US.
Organisations that routinely need to borrow shares and bonds include hedge funds for strategic shorting purposes; market-markers to cover their activity and realignment; Delta One trading desks of investment banks; and brokers to cover extraordinary demand.
All four already use ETFs, but their popularity is growing. ‘ETFs are reaching into parts of the market beyond long only,’ says Paul Young, Head of ETF Capital Markets EMEA, SPDR. ‘Delta One hedging, for example, used to be futures while we are seeing more short-sellers use ETFs to express market views.’
Young and others expect that gap to close as asset owners become aware of the extra income potential from lending ETFs; market initiatives assist agency lenders to locate more ETFs; and non-cash collateral becomes more attractive to risk-taking financial institutions.
The two sides of securities lending
Because they are single shares issued on numerous stock exchanges, ETFs can be short-sold just like any other publicly-traded security. And, as their status as a type of financial instrument matures, ETFs are also increasingly being offered to fulfil the other side of the security lending trade as collateral.
Europe has seen an increasing use of non-cash collateral in securities financing transactions over the last ten to fifteen years. More recently this has been driven by banks requirements under new regulations to be ever more balance sheet and capital efficient with inventory.
Matthew Fowles, iShares, expands: ‘While government bonds have always been widely accepted, main index equities are now also well-established as eligible collateral. What we are witnessing is ETFs finally entering the mainstream as a viable form of collateral.’
Liquidity continues to be top of mind and the adoption of ETFs in collateral schedules is gathering momentum. Amongst others, leading agent lenders State Street and BlackRock accept ETFs as collateral, with many other institutions now reviewing them for the very first time.
It is even now possible to borrow one ETF by pledging another ETF as collateral. or It is even now possible to short sell one ETF against another ETF as collateral. This is evidence of how popular ETFs have become in Europe, although they remain far from ubiquitous for a number of reasons.
Towards a total overview
In the US, a central trade data system is available with mandatory reporting for all trading venues. Transparency is also reinforced by the obligation to provide best execution determined solely by price. The US therefore has an efficient system of pre-and post-trade transparency. European rules do not require obligatory reporting with an estimated 70% of volumes privately recorded as over-the-counter agreements. A lack of transparency of trading levels results in uncertainty about the liquidity of certain ETFs.
On the lending side, there is another barrier: the lack of oversight of total availability of the lending pool across different markets. The same ETF in name might be listed on stock exchanges in London, Frankfurt, Paris and Milan but agency lenders will likely only see information on their local sedol code. In this sense, Europe is a fragmented ETF market.
Of course, it is only a matter of a few clicks to explore further afield, but this is still a line-by-line hunt rather than what agencies in a mercurial trading environment really need: a total European overview of any ETFs availability.
Young observes that current conditions give the impression that liquidity is far lower than is the case, which creates lack
of confidence in agency lenders and pushes up the price of lending ETFs.
The second major obstacle has been the lack of a systematic means of analysing the collateral value of ETFs. Trust in ETFs
as an asset management instrument is high. But collateral management is a risk-averse business.
Collateral managers think in terms of worst-case scenarios and want to be able to value exactly what they will get if disaster strikes while they have loaned out or accepted stock. This can be a difficult exercise with ETFs. There are many different variations to consider such as synthetic versus physical, leveraged / non-leveraged, inverse etc. with a multitude of indices / exposures tracked, including equities, bonds, property and commodities.
‘This complexity and lack of systematic ability to look ‘under the hood’ of an ETF results in a very time consuming and inefficient process for risk managers to review, accept and manage ETFs within collateral schedules’, explains Fowles.
‘The varied construction and exposures, coupled with the lack of standardised approach for accepting ETFs as
collateral, has held back their usage in this sector.’
Better visibility and lower costs
In spite of these obstacles, one reason why agency lenders and ETF issuers are confident that the securities lending market will grow has been an initiative from Euroclear. By working with different issuers on an issuance model that enables ETFs to be traded in multiple venues , even beyond Europe, and settled easily in an ICSD, the market hopes to eliminate the need for re-alignment or multiple ISINs. The use of single identification numbers (ISINs) places ETFs issued in this model above the siloes of sedol code, giving agency lenders the opportunity of a centralised depot in Europe and so easier fulfilment of demand from borrowers anywhere.
Fowles says this initiative will make a huge difference, making the ETF lending market more like the US, harmonising bid-offer spreads and making these instruments more fungible.
According to Mohamed M’Rabti, deputy head of Global Capital Markets at Euroclear, more than 90 ETFs, from the likes of CCBI, PIMCO, State Street and iShares have already been issued in the new format. They are now benefiting from the advantages of the international model.
Market participants, especially agency lenders, will still have to be encouraged to search by ISIN rather than sedol to reap all the benefits of this model. But Young reckons that if lenders do start assessing availability via the primary markets, this initiative could ultimately replace much of the current need to create and redeem ETF shares.
Regulation will also give market participants a boost when Mifid II requires ETF trading volumes to be reported. This is part of a greater trend towards central clearing and transparency. Specifically, for agency lenders, the Mifid II regulation will make Europe more like the US by producing a more accurate, fuller sense of ETFs’ liquidity.
Elsewhere, agency lenders have already received a boost in their efforts to foster broader acceptance of ETFs as collateral from Markit. The data provider has devised a pair of reference lists of ETFs suitable for use as collateral. Qualification is decided by seven criteria. For example, on the equity index only products holding physical underlying securities are eligible while leverage is not permitted.
According to Markit, constituents of its two inaugural collateral ‘lists’ already represent 15-16% of the global ETF Market.
Fowles believes this is a landmark development. Firstly, the ETF collateral ‘lists’ establish an efficient process for risk manager review. Instead of a line-by-line appraisal, only the consideration of seven criteria is required. Secondly, it provides the long overdue transparency that will enable broker-dealers to better match against their inventory and ultimately standardise the ETF collateral market.
In the past every collateral receiver would have their own qualifying set of criteria and line by line list of eligible ETFs.
Brokers would have to know each specific list to build up a general picture of which ETFs were acceptable, notes Fowles who believes the Markit lists go a long way to helping everyone to understand and agree an acceptable core of ETFs.
The power of communication
The initiatives outlined here are well-thought-out responses to problems in market liquidity and distribution. While these technical initiatives gather apace, agency lenders and issuers reckon there is also a role for direct communication and education in nurturing more business.
‘I am sure there are a lot of ETF holders out there who are simply not aware that securities lending is possible,’ says Neil Cracknell, head of European equities trading at State Street. Logically, he believes that the high fees around ETFs in this field will fall if the lending supply can be increased.
His colleague, Cathrine Poulton, client relationship manager in Securities Finance at State Street believes a beneficial spiral of ctivity will be fostered by communication between borrowers and lenders, facilitated by middle parties such as custodians and agency lenders. She says that the power of communication and education in practically growing this market cannot be underestimated.
Fowles agrees, claiming that in the absence of an efficientlending market for brokers, iShares is always happy to facilitate connections between borrowers and lenders, for example when a well-traded ETF is to be found in an unusual place.
ETFs adapt to a new era
All the interviewees for this article agreed that there is much to do before ETF securities lending in Europe realises its potential. Utilisation, for example, still languishes consistently below 5% of available assets in Europe, compared with 20-40% in the US (SLT Markit ETFs as Collateral survey, 2015).
There are suggestions this could be partly due to the cost of new securities lending regulation.
Regulation’s intention, however, has been not to halt securities lending but to make it systematically safer. This is the ethos of our times. By fostering greater transparency, market initiatives such as Euroclear’s internationally issued ETF are entirely in keeping with this ethos. They also should reduce costs by cutting the number of failed trades and encourage more lending revenue.
‘I am confident that ETFs will adapt to this new era and grow stronger,’ notes Fowles. ‘In many equity and fixed income exposures, ETFs are an increasingly more efficient vehicle than say futures and credit index derivatives.’ He believes that as ETFs become a buy-and-hold instrument for asset owners, so levels of availability and borrower demand will rise in tandem.
Poulton adds that if capacity rises, then ultimately long-term borrowers will get what they want, which is price stability. M’Rabti says that Euroclear will continue to keep working with the industry towards all these mutually beneficial goals by listening to and collaborating with all players in the market.
M’Rabti ends: ‘The gap between European US ETFs and securities lending will eventually close. What is more, I am confident that equity finance, which exists for equities today, will function in the same way for ETFs.’