March 2018

SECURITIES LENDING: The tipping point

Tipping_pointETFs are increasingly accepted as collateral in securities lending transactions. Nicholas Pratt looks at the impact of this change and how acceptability could go further still.

In January, Citi announced that it was accepting exchange-traded funds (ETFs) as collateral for its agency securities lending programme. The ETF market continues to grow with close to $5 trillion (€4 trillion) in global assets under management (AuM). Meanwhile investors’ need for a greater and more diversified pool of collateral is also rising in the face of rising margin requirements and the introduction of new regulations such as MiFID II.

“The AuM in the ETF market has grown spectacularly over the last five years,” says Andrew Jamieson, global head of ETF product and managing director at Citi. “Furthermore, ETFs have become a staple of the institutional investment world with large buy-side firms, many of whom are Citi customers, increasing the size of their ETF investments.”

However, when it comes to accepting ETFs as collateral, there have been two main stumbling blocks – firstly the difficulty in assessing the explicit liquidity given that so many ETF trades are done over the counter (OTC).

Trade reporting rules under MiFID II should help bring more transparency to OTC transactions and an ongoing education effort from the ETF market has helped investors and risk managers understand the mechanics of these instruments.

The other impediment has been the onerous process of assessing ETFs’ suitability for collateral. The lack of an industry-wide index or benchmark of eligible ETFs means that many agent lenders and collateral managers have to assess ETFs on a one-by-one, line-by-line basis.

Attempts have been made to address this, most notably by data provider IHS Markit, which publishes two lists of eligible ETFs, for equities and fixed income respectively. This has helped investors meet their due diligence challenges when it comes to ETF selection. Indeed, Citi will be using the index as the basis for determining eligibility for ETFs accepted as collateral. “IHS Markit does the heavy lifting in terms of eligibility, although we do retain the flexibility to add further criteria,” says Jamieson. “For example, if there is a particular country or security in the underlying securities.”

But the question for the industry is how this list can be expanded without sacrificing good risk management practices.

Modernisation
The IHS Markit lists have been in operation for roughly two years. “The idea was to get the asset class more widely accepted as collateral,” says Siamak Mashoof, head of ETF Product at IHS Markit. “We hold a huge amount of information on ETF and collateral markets and are engaged with as many stakeholders across the community, including securities lenders and borrowers, triparty agents, beneficial owners and ETF issuers.”

In the course of these discussions, IHS Markit found the risk assessment process on the collateral management side “could benefit from some modernisation”, says Mashoof.

IHS Markit produced two lists of ETFs deemed acceptable for collateral – one for equities and another for fixed income – that were based on conservative but fundamental criteria.

The ETFs must be replicated or optimised, physically backed and with no leverage factor.

Two years on from the initial publication of the lists, there are currently around 70 ETFs in the equities list and 40 in the fixed income list. Each month the list is re-sent based on the AuM (which must be over $100 million) and tracking difference ( less than 1%), as well as the aforementioned criteria.

While an ETF can be taken off the list at any time should it fall below $100 million AuM, no ETF can be added until the beginning of the next monthly cycle.

There is a clear appetite for more ETFs to be added, says Mashoof. There are also plenty of ETFs available but not on the list, from the roughly total universe of $5 trillion worth of AuM. “The agent lenders want more ETFs on there, as do the issuers, who want the criteria widened to include synthetic ETFs and are even issuing new ETFs specifically to get them on to the list,” says Mashoof.

According to IHS Markit data, availability in the iShares European listed ETF range has increased more than 50% since January 2016 to more than $20 billion, as an increasing number of ETF investors add their holdings to lending programmes, says Patrick Mattar, head of BlackRock’s iShares EMEA capital markets.

‘A long way to go’
It may have taken time for the agent lenders to consider accepting ETFs given competing priorities, says Mattar. However, the majority of lending agents have either approved the use of ETFs or are at least going through the process.

Those that do not accept ETFs probably believe there is a lack of demand to deliver from their borrower counterparts rather than any opposition to the idea.

“I feel we are at a tipping point,” says Mattar. “There has been significant growth but there is still a long way to go. We have much better data now so that we are able to show agent lenders and beneficial owners the merits of lending and accepting ETFs. And the fact that we are seeing an options market for ETFs developing in Europe is evidence of a healthy loan market able to trade risk in a safe and orderly manner.”

Brian Staunton, managing director of BNY Mellon Markets, was one of the participants in the first industry working group that helped to produce the initial collateral list published by IHSMarkit. The bank subsequently implemented the lists into its collateral eligibility programme.

“The use of ETFs as collateral has gone up since then, but it has been from a zero base. If you consider the size of the ETF market, there is still a lot of room for growth,” says Staunton.

The list is a step in the right direction, he adds, and makes the process of ETF selection more automated and more efficient, but more could be done to bring the collateral takers and agency lenders on board.

“We need to get to a place where we have an index of ETFs just like we have in equities,” says Staunton. What IHS Markit has produced is a list rather than an index, an important distinction given the legal ramifications that come with being an official index provider.

The creation of an ETF index would have to be industry-driven and not led by a single institution, he says, and it would have to include the collateral receivers (the agent lenders), as they are key to developing the market.

State Street has accepted ETFs as collateral in its securities lending transactions since 2012, says Jamila Jeffcoate, head of agency lending for EMEA at State Street.

“We generally respond to market demands for collateral and accepting ETFs was one of them. Our borrowers put forward suggestions as to the ETFs they would like to pledge and we review these requests on a case-by-case basis.

”We try and follow a rule of thumb and to be as flexible as possible. We look at geographic focus, market capitalisation and liquidity. We also look at concentration limits and a minimum price threshold for any ETFs that we take,” says Jeffcoate.

The question for the industry now is how to continually add to the eligibility criteria, she adds. “We are adding to our eligible inventory for ETFs all the time, but the supply of European ETFs being used as collateral is still relatively thin compared to the US.”

BNP Paribas Securities Services has accepted ETFs as collateral for several years using its own internal collateral eligibility criteria, says Adnan Hussain, global head of agency lending and MFS UK. This is managed under the overall risk and collateral management oversight of the AGL business, which is undertaken independently by the BNP Paribas Group.

As with the collateral list produced by IHS Markit and on which Citi bases its collateral acceptance, BNPP SS’s criteria is that the ETF is based on an index that the client accepts. “I do encourage lenders that are looking for diversification and already accept equities to accept ETFs as collateral,” says Hussain. “A basket of multiple ETFs provides greater diversification with respect to risk than an equivalent basket of diversified equities.”

Struggling
Another issue is the onerous task of assessing the eligibility of ETFs from a collateral management perspective. “We have a list of more than 1,000 ETFs that are acceptable,” says Hussain. “We assess them individually in correlation to the list of acceptable equity indices. In general, the industry is struggling to find an efficient process. Agent lenders, third-party agents and borrowers all struggle with how to manage the list of eligible ETFs.”

Along with other agent lenders, Hussain would also like to see an ETF index. “If you have a widely recognised benchmark of ETF indices, that would help identify whether any given ETF fits the basic long-only, physical and liquid criteria, that would be very helpful for counterparties to identify acceptability when pledging this instrument,” he says.

So what happens now? “We are hoping to have another roundtable with all the relevant parties and try to reach general consensus about the launch of the second iteration,” says IHS Markit’s Mashoof. “The real golden goose is for the list to become a standardised schedule for ETFs and then for national-specific sub-groups to be added on top, but we will be steered by the collateral community.”

©2018 funds europe