REGUALTION: Falling in line with Esma

Regulatory scrutiny has put the focus on stock lending. Funds Europe asked a range of exchange-traded fund providers for reaction to this issue and others raised by the European Securities and Markets Authority.

The European Securities and Markets Authority (Esma) concluded a review of exchange-traded funds (ETFs) and other Ucits-regulated index tracking vehicles in July 2012. The debate behind the consultation centred, at least for a time, on synthetic ETFs, which use swaps to replicate returns from the indices they track.

Esma voiced concerns about the increasing use of synthetic and more complex structures by ETF providers.

The regulator felt this created investor protection and market integrity issues.

A major issue was counterparty exposure through the swaps. But the focus also shifted on to physical ETFs, which use actual securities to track indices. It became better understood that stock lending also carries counterparty exposure.

Esma raised a further issue with stock lending: how asset managers that manage ETFs treat profits from lending activity. It would prefer to see profits sent back to the fund.

One of the technically challenging factors was for ETF providers to ensure appropriate redemption conditions for secondary market investors by opening funds for direct redemptions when liquidity in this market is not satisfactory.

Tim HuverTIM HUVER, ETF PRODUCT MANAGER, VANGUARD ASSET MANAGEMENT

How can a solution for providing direct redemption for secondary market investors at a time of low liquidity be achieved?

In line with the Esma proposals, we have developed a process for handling ETF transactions from secondary market investors. Vanguard offers mutual funds and ETFs, and the account set-up, investment management and settlement process is very similar to the infrastructure already in place for both products.

Do you lend securities within your ETF products and what has been your policy regarding revenues from this activity? What do you think of Esma’s rule that all revenues net of costs should be returned to the ETF?

As standard Vanguard policy, all the new funds or ETFs that we offer progress through a seasoning period before we add them to our securities lending programme. We have not yet added the ETFs to our programme, but intend to do so in the future.

We are very much in favour of the recent Esma guidelines on lending, as these are consistent with our philosophy on lending by ensuring alignment of lender and shareholder interests. We
take a very conservative, shareholder-focused approach to lending. Since the inception of Vanguard’s lending programme, we have always credited 100% of the net revenue to the funds to benefit all fund shareholders.

Esma wants ETFs to “be able at any time to recall any securities lent or terminate any agreement into which it has entered”. How easy will it be to make this happen?

All loans completed within Vanguard’s securities lending programme are open-ended and we do not offer fixed-term loans. This means that the loans can be terminated by the borrower or lender at any time, through the return or recall of borrowed shares. Therefore, the proposed guidelines are consistent with our approach to loans.

How would you describe the quality of the collateral you receive to mitigate counterparty risk from over-the-counter (OTC) derivative transactions or efficient portfolio techniques?

First, it is a Ucits requirement that all OTC counterparties have a minimum short-term credit rating of A-2/P-2. For swaps/forward foreign exchanges, eligible collateral is generally considered to be short-dated, highly liquid, high-quality obligations – like US treasuries. Investment in derivatives in our ETFs will only be used for efficient portfolio management, and typically represents a very small portion of the portfolio. For securities lending, only cash collateral is accepted.

Is it practical for investors to receive full calculation methodologies for financial indices?

Yes, the calculation methodologies are currently available on the sites of the major index providers.

Townsend LansingTOWNSEND LANSING, HEAD OF REGULATORY AFFAIRS, ETF SECURITIES

How can a solution for providing direct redemption for secondary market investors at a time of low liquidity be achieved?

The direct redemption issue, if you will, is not one of liquidity, as most exchange-traded products (ETPs) reference liquid assets. If liquidity is low, it will be low for both secondary as well as primary market investors. The real issue is the logistical issue of whether or not ETP issuers can identify holders in the secondary market.  

Most ETPs are dematerialised; as a result, the holders only appear in the form of the relevant nominee account – per industry practice for central securities depositaries.  This fact, in turn, makes it difficult for an ETP issuer to identify a secondary market holder as the true holder of the underlying security, which in turn makes it procedurally difficult to allow for direct redemptions.

Do you lend securities within your ETF products and what has been your policy regarding revenues from this activity? What do you think about Esma’s rule that all revenues net of costs should be returned to the ETF?  

We do not engage in securities lending. We believe the Esma guidelines on ensuring that securites lending revenue is allocated to the party bearing the underlying lending risk – that is, the fund – is the correct approach.

How would you describe the quality of the collateral you receive to mitigate counterparty risk from OTC derivative transactions or efficient portfolio techniques?  

We believe our collateral criteria – including the collateral that is eligible, the appropriate haircuts and daily publication of the collateral holdings – is of high-quality and reflects best practice among the industry.

Is it practical for investors to receive full calculation methodologies for financial indices?  

There are two issues here: whether the index is fully transparent; and whether the index constituents should be delivered to all investors at the same time.  

For the first issue, we believe that Ucits funds should only directly invest in those indices that are fully transparent. However, we recognise that index providers have proprietary interests in their index data and that any rules with respect to that data must ensure those interests are protected.

Isabelle BourcierISABELLE BOURCIER, HEAD OF BUSINESS DEVELOPMENT, OSSIAM

How can a solution for providing direct redemption for secondary market investors at a time of low liquidity be achieved?

Today, trading for those instruments occurs on an exchange via brokers or through an authorised participant. If those two options are not available, then the possibility for existing investors to redeem their shares directly should be available. However, the impact of a solution on the operational set-up needs to be considered. In addition, a lack of liquidity in the ETF might also come from a lack of liquidity in the underlying market.

Do you lend securities within your ETF products and what has been your policy regarding revenues from this activity? What do you think about Esma’s rule that all revenues net of costs should be returned to the ETF?

We do not lend securities within any of our ETFs.

Esma wants ETFs to “be able at any time to recall any securities lent or terminate any agreement into which it has entered”. How easy will it be to make this happen?

As far as recalling securities or terminating the agreement are concerned, a key issue is to know in what conditions and time frame it can be done. However, if there is no strict limitation on time, the question of the quality and diversification of the collateral is key.

How would you describe the quality of the collateral you receive to mitigate counterparty risk from OTC derivative transactions or efficient portfolio techniques?

For the majority of our ETFs we use the so-called unfunded swaps structure. Ossiam applies Ucits diversification rules to the substitute basket – that is, the assets inside the funds, where the fund is the sum of the substitute basket, a total return swap and a small amount of cash, if applicable.

We believe the whole market globally should apply the same rules. This guarantees sufficient diversification should a swap counterparty default, when the fund manager will either find a new swap counterparty or will liquidate the substitute basket to buy the index components.

Is it practical for investors to receive full calculation methodologies for financial indices?

In many cases, calculation methodologies can be downloaded from the index provider websites and, in our case, from our website. ­However, one needs access to the data to recalculate the index. Those data are not free of charge.

Practically, this may therefore not be accessible to all investors. Besides details of the index, underlying components and corresponding sector and country breakdowns are also very important for investors’ understanding of inherent biases of the indices. Currently, some index providers agree to give the composition of an index, but with a lag in order to prevent front running by arbitrageurs.

Michael LytleMICHAEL JOHN LYTLE, MANAGING DIRECTOR, SOURCE

How can a solution for providing direct redemption for secondary market investors at a time of low liquidity be achieved?

This issue has been identified by Esma and will be addressed by a working group of fund administrators, transfer agents and product providers liaising with local regulators to develop a practical solution. It should be noted that the vast majority of fund investors of both traditional funds and ETFs do not hold their units directly but through their bank or nominee account.

Do you lend securities within your ETF products and what has been your policy regarding revenues from this activity? What do you think about Esma’s rule that all revenues net of costs should be returned to the ETF?

Source does not engage in stock lending in its ETFs. Generally, our view is that markets are most efficient when left to find their own levels.

Esma wants ETFs to “be able at any time to recall any securities lent or terminate any agreement into which it has entered”. How easy will it be to make this happen?

Source does not engage in stock lending. It is our general understanding that lent securities can be recalled but there may be a penalty for early termination.

How would you describe the quality of the collateral you receive to mitigate counterparty risk from OTC derivative transactions or efficient portfolio techniques?

For Source’s funds that utilise OTC derivatives, the exposure to each counterparty is capped at 0.2% so there is no need to arrange for the posting of collateral. Instead, Source simply resets the swap thereby eliminating the exposure.

Is it practical for investors to receive full calculation methodologies for financial indices?

It is practical for investors to have a complete understanding of the way that an index functions and the method of daily calculations but it is rarely possible for them to mirror the daily actions of the index calculator down to the last basis point, even on some of the most straightforward indices.

©2012 funds europe