Securities industry veterans Roy Zimmerhansl and Andrew Howieson have published a white paper calling for structural changes in the European ETF market to facilitate the more widespread lending of fund shares.
A more active securities lending market in ETFs, say Zimmerhansl and Howieson, will provide a critical boost to the secondary market liquidity of European ETFs. The liquidity of European ETFs in secondary trading is currently significantly below that of the US ETF market.
Investors would also benefit from more widespread securities finance activity in ETFs, say the authors.
“Currently European investors take a double hit when using ETFs,” said Roy Zimmerhansl at a press conference in London on Monday to mark the publication of the white paper, ‘ETF Liquidity, Securities Finance and Collateral Management’.
“The inability to lend ETFs means that investors pay higher bid-offer spreads in the secondary market, as well as missing out on the potential lending revenues when holding them,” said Zimmerhansl.
Zimmerhansl and Howieson stressed that their research should be seen as having a different objective to that of the recent UCITS/ETF guidelines issued by the European securities regulator, ESMA.
“[Our] focus...is on the trading and operational mechanics related to the lending, borrowing and financing of ETFs, which are separate and distinct from the issues that receive attention in the ESMA paper,” say the authors.
From a securities finance perspective, ESMA’s guidelines paid particular attention to the balance between risk and reward when ETF managers lend out shares from their funds’ portfolios. ESMA also requested that fund investors receive of all the income associated with securities lending, net of any costs incurred by the manager or its lending agent.
The ways in which ETFs and the securities finance market interact are complex, say Zimmerhansl and Howieson, and fall into six broad categories, which the authors spell out in the white paper.
First, say the authors, there’s the lending of the underlying securities from an ETF using physical replication (owning the securities of the index being tracked). This practice, the focus of ESMA in its recent guidelines on UCITS, is broadly accepted and “used to offset the relatively high replication costs and tracking errors inherent in physical replication ETFs,” say the white paper’s authors.
Second, note Zimmerhansl and Howieson, there’s lending from the substitute basket held by a synthetic (derivatives-based) ETF. This, however, say the authors, is not a widely accepted practice, since securities that are in demand in the securities finance market are unlikely to find their way into ETFs’ substitute baskets.
The third area of overlap between European ETFs and securities finance—lending from a basket of pledged collateral in an ETF following the so-called funded (or prepaid) swap model—should in theory be prohibited as the collateral is held either in the name of the ETF issuer or in the name of the swap counterparty, under pledge to the ETF issuer. In either case, say Zimmerhansl and Howieson, the collateral should not be available for lending as under standard pledge arrangements the assets remain under the ownership of the pledging counterparty.
Lending ETF shares, the fourth area of intersection of ETFs and securities finance, is a widely accepted practice in the US market and the focus of Zimmerhansl and Howieson’s white paper.
The mechanics for lending ETF shares are the same as when lending other securities, the authors point out. That means ETFs, like shares, are lent either by agent lenders representing institutional investors, prime brokers representing hedge funds or by investment banks acting on a principal basis.
However, they continue, there are a number of complex factors inhibiting the development of the ETF lending market, especially in Europe.
Investors may not be aware that ETFs can be lent, say Zimmerhansl and Howieson, while agent lenders may restrict the volume of ETFs available for lending by allowing only a fixed proportion of the reported daily trading volume in these funds to be lent.
Since a large part of European ETF trading takes place off-exchange and is unreported, using conventional measures of secondary market liquidity like average daily trading volume (ADTV) significantly understates the true liquidity of ETFs, the authors argue. Recognising this should significantly reduce the concerns of borrowers worried about recall risk and lenders concerned about counterparty default and the speed with which loaned ETF shares can be repurchased.
The fifth area of intersection of ETFs and securities finance—so-called “create-to-lend”—is again more common in the US than in Europe, say Zimmerhansl and Howieson.
Create-to-lend involves ETFs’ authorised participants (APs) creating ETF shares with the specific intent of lending them. The demand for create-to-lend is driven by arbitrage opportunities, as well as by a desire from market participants to short an ETF when it is not available for borrowing in the market.
However, say Zimmerhansl and Howieson, the use of create-to-lend is limited in Europe because of the costs inherent in ETF creation and redemption and as a result of technical issues involving differences in the treatment of dividends between ETFs and individual stocks.
The sixth and final area of common ground between ETFs and the securities finance market involves the use of ETFs themselves as collateral by market participants. Here, argue Zimmerhansl and Howieson, while few market participants currently accept European ETFs of any kind as collateral for securities loan, equity repo or other financing transactions, ETFs merit much wider use for this purpose.
Specifically, say the authors, a number of ETF features make these funds highly suitable for use as collateral in securities finance transactions: ETFs’ tradeability in the secondary market, their in-built creation and redemption mechanism, and the ability to offset ETF exposure by futures covering the same market indices.
However, argue Zimmerhansl and Howieson, for ETFs to be used more widely in the securities finance business, several improvements in market infrastructure need to be made. An industry-wide classification system is sorely needed for ETFs, they say. Such a system has so far proved hard to agree on, given the widely differing commercial interests of fund issuers. Action is also needed from market participants to define best practice when lending ETFs and using them as collateral.
Zimmerhansl and Howieson’s white paper was sponsored by a range of participants from the ETF market, including one issuer, two custodians, a stock exchange, two market-making firms and a clearing bank.
A version of the white paper will be published in the forthcoming, November/December issue of the Journal of Indexes Europe.