EXCHANGE-TRADED FUNDS: Missed opportunities

An efficient ETF lending market in Europe could benefit all participants. Nicholas Pratt examines what is being done to create one.

The holders of European exchange-traded funds (ETFs) are missing out on significant sums because of the lack of an efficient lending market for ETF units. This is the view of several ETF providers who are challenging custodians and agent lenders to address this deficiency.

The European ETF market is worth approximately $400 billion (€321 billion) yet only a fraction of this, around $2 billion, is available to loan. The rest of the ETFs are sitting in custody. In contrast, ETFs make up around 20% of the daily trade volumes in the US securities lending market. 

There are a number of reasons for the situation in Europe, says Andrew Jamieson, head of broker-dealer and client execution sales in Europe, the Middle East and Africa (EMEA) at iShares. “Firstly, I don’t think custodians fully appreciate the opportunity that exists, so they have not sufficiently resourced it yet. Secondly, some are also blissfully unaware of the inventory they hold, as their antiquated systems cannot categorise the ETFs successfully within their collateral inventory.” 

The situation is exacerbated by the fragmented landscape of the European ETF market. Unlike the US, where all ETFs are listed, traded and settled in one place, ETFs in Europe are listed in multiple venues and this makes trading much more complex when it involves moving an ETF from one market to another. However, the emergence of an international central securities depository (ICSD) model for ETF issuance and settlement may help to reduce the complexity of the European marketplace, says Jamieson. 

“This new model will help bring more harmonisation and reduce the cost of ETF trading,” says Jamieson. “It will also allow multiple listings to continue. The work is done on the back end.” 

In addition to iShares’ ongoing effort to convert its ETF range into the new format, State Street has also committed 13 of its funds to the ICSD model. 

It is not just custodians that are holding up the development of an ETF lending market. There are also issues with lenders and borrowers, says Gregoire Blanc, head of capital markets at Lyxor. “On the lending side, a lot of ETF investors are unaware that their holdings could be lent out so there is a limited pool available.”

The limited supply of ETFs leads prospective borrowers to assume there is limited availability, which subsequently reduces their demand, says Blanc. “When they try to get an ETF, they find that not enough are available and the ones that are available come at a high price.”

There is often also a misguided impression of the liquidity within ETFs from both lenders and their agents. “The different levels of liquidity within an ETF are often overlooked. The lenders are often looking only at secondary market liquidity and not the liquidity and diversity of the underlying assets,” says Blanc.

The numerous custodians without lending programmes for ETFs also need to take a more consistent approach when judging what assets are suitable for lending, says Blanc. “Many custodians will consider a basket of securities from the FTSE 100 index as suitable for lending but not an ETF that tracks the same index. That is not consistent and does not make sense.”

“Custodians should realise that ETFs are here to stay and they would benefit from including them in their securities lending programmes. Of course, it has to be done properly in terms of due diligence, but the barrier is the perception of low liquidity not high risk,” says Blanc.

The due diligence process should be made easier and the liquidity of ETFs be made more evident once the second Markets in Financial Derivatives (MiFID II) comes into effect, says Blanc. “ETFs are included in its reporting requirements, including any OTC [over-the-counter] trading. This will make [ETFs] more transparent and make it easier to assess the different levels of liquidity.”

It is self-evident that the European market for ETF securities lending is less efficient than the US’s, says James Day, head of securities finance, EMEA at BNY Mellon. One reason is the structure of the European ETF market. “ETFs are listed on multiple exchanges so there are a number of different marketplaces to deal with. This not only fragments the liquidity, it also makes it more complex to accurately reflect the data of the ETFs within the custody systems.”

BNY Mellon has spent time assessing its systems to make sure any clients within its securities lending programme that are holding ETFs are aware they can be made available to lend. 

Day does agree that some custodians may not be aware of the full extent of an ETF’s liquidity. “Most ETFs are traded via the authorised participants on an over-the-counter basis. So if custodians are looking only at the on-screen liquidity, they will only see a portion of the liquidity. Custodians need to make sure that they see the full picture.”

In addition to promoting the benefits of ETF lending to beneficial owners and potential borrowers, BNY Mellon is also engaged with ETF providers to accept more ETFs as collateral. “We have collateral guidelines for our lending book and in order to be comfortable with ETFs, we would need to know that, in the event of a default, we could get access to the underlying assets to liquidate them should we need to.”

There are also steps that ETF providers could take to make life easier for custodians. The fact there are so many different ETF providers, all with their own nuances, makes it more difficult for custodians to undergo that due diligence. 

Day says efforts are underway to develop an ETF index so that all ETF providers have to meet the same criteria in ensuring that the ETFs are physically backed and fully convertible. Not only would this make it easier for custodians to identify which ETFs are suitable for lending, the acceptance of ETFs as collateral would make them more in demand for lending and also bring a general respectability to the asset class among both lenders and borrowers.

This is a view shared by a number of ETF providers that are looking to reach out to custodians as well as potential lenders and borrowers. “I think a co-ordinated approach would be a good way forward,” says Keshava Shastry, head of capital markets at db x-trackers, the ETF arm of Deutsche Bank, who backs the idea of a standardised ETF index for custodians. “We are not suggesting that custodians open the floodgates. Risk management is a key aspect of securities lending, but the risk management side is very well developed.”

There is a similar development currently concerning the use of ETFs as collateral, which Shastry says will help push the case for ETFs to be seen as suitable assets for lending and borrowing. “There are three characteristics that make them much more suitable than other stocks – they have lower volatility versus a single stock, they are more diversified, and they have two sets of liquidity: primary and secondary markets.”

In the absence of an efficient ETF lending scheme, there are some alternative approaches available. The create-to-lend scheme is an existing mechanism whereby brokers and authorised participants, with the cooperation of the ETF issuers, are able to create ETFs requested by brokers specifically for shorting purposes. But there are frictional costs involved in such a scheme, like broker payments and transaction taxes, so issuers would prefer to use the natural supply of ETFs for lending, says Shastry. 

Until these initiatives – the ETF index, the acceptance of ETF as collateral, the transparency rules from MiFID II and the continued effort to automate the system – bear fruit, ETF issuers will have to continue educating market participants on the many benefits that a fully functioning ETF lending market would provide, especially for ETF holders. 

There are potentially some significant lending revenues on offer, says Shastry, which will help offset the total expense ratio of an ETF for the ETF holders and create extra revenue for custodians and lending agents. As a rough guide, Shastry says that any beneficial owner lending FTSE 100 index stocks should take a weighted-average lending rate as an indicator of the price at which they could be lending an ETF based on the same index.

For asset managers and hedge funds, borrowing an ETF would allow them to make macro hedges and provide an alternative to using futures. For the ETF providers it would allow their products to mature and bring new investors into the ETF ecosystem, creating further benefits for end investors such as spread compression and improved settlement rates. And ETF market makers would see their costs reduce because of more accessible ETF inventories.

Fortunately, there are precedents that suggest an efficient ETF lending market will materialise in Europe. “We saw a similar thing with global depositary receipts back in the 1990s,” says Lyxor’s Blanc. “At first they were not included in sec lending programmes but they were gradually accepted and now they are fully used for sec lending and accepted as collateral. I expect the same thing to happen with ETFs.”

©2015 funds europe



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