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Managers hit by securities lending rules
25 July 2012
The European regulator has published final guidelines for ETFs and other Ucits issues, with key topics being securities lending and collateral diversification
The European Securities and Markets Authority (Esma) has published highly-anticipated guidelines for exchange traded funds (ETFs) and other Ucits issues following the results of its consultation held earlier this year.
The rules cover efficient portfolio management (EPM) techniques used in Ucits such as securities lending where Esma now requires all revenues net of generating cost generated by these activities to be put back into the fund. According to Esma, EPM techniques also include repo and reverse repo arrangements.
“There is no reason why some of the revenue from securities lending in Ucits ETFs should go to the manager when the only person taking risk on that is the investor,” an Esma spokesperson told Global Investor/ISF this morning.
Esma also introduced rules to improve transparency and risk management in securities lending. Ucits that are active in securities lending will be expected to inform investors clearly about these activities and related risks. Funds will also be expected at any time to recall any securities lent or be able to terminate the contract.
However, Esma decided not to introduce a cap on the percentage of securities allowed to be lent out in a Ucits fund. This has been a topic of intense discussion, particularly in the physically-replicating ETF industry where BlackRock recently introduced a 50% securities lending cap on its European physical ETFs.
The Esma spokesperson said: “We decided not to implement a concrete securities lending cap because Ucits ETFs have the obligation to be able to meet redemption requests from investors which therefore restricts the amount of the assets than can be lent out. However, we have introduced clear criteria for the collateral to be posted to the Ucits."
Global Investor/ISF was told recently by several market participants that ETF providers could look to introduce an industry-wide securities lending cap if it is not implemented by regulators.
Despite the focus on securities lending activity which is used in physical-replicating ETFs, Esma said its guidelines did not distinguish between physicals and synthetic-repliacting ETFs because "we have concerns for both" and that they are "quite similar in terms of counterparty risk". For the past two years there has been heavy debate over whether synthetic ETFs are riskier than physical ETFs, and vice versa.
Esma also mandates that UCITs that receive collateral to mitigate counterparty risk from OTC derivative transactions or EPM techniques should have to ensure the collateral complies with the strict qualitative criteria and specific limits in relation to diversification. Based on feedback from consultation respondents, Esma decided to modify its approach for the diversification of collateral.
The regulator had originally proposed to require the combination of collateral and assets not subject to EPM techniques to respect the Ucits diversification. The final guidelines now recommend that quantitative criteria only apply to each basket of collateral received from each counterparty of OTC derivative transactions or EPM techniques.
The above rules will have a significant impact on physically-replicating Ucits ETFs which tend to rely on securities lending to increase revenues. Currently the standard format used is a revenue sharing agreement. For example, BlackRock’s in-house securities lending operation keeps 40% of the revenue and gives back 60% to the fund. Vanguard is one of the very few ETF providers that give back 100% of income made from securities lending.