ETFs to evolve into major part of European sec lending

ETFs to evolve into major part of European sec lending

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In a squeezed securities lending business, a potential boom in lending units of European exchange traded funds (ETFs) is a remarkably appealing prospect.
In theory, all parties only stand to gain. By lending units of ETFs themselves (as opposed to the widespread practice of lending shares contained within an ETF) potential beneficial owners can further offset the already low costs of ETF ownership and end users have a neat solution for hedging or taking short macro positions. Meanwhile, agent lenders and broker-dealers widen their business to cover to an increasingly popular type of asset. 

“All participants within the securities lending market should consider lending ETFs. There is an expected, natural evolution that ETFs will become a major part of the securities lending system,” says Keshava Shastry, head of exchange traded products, capital markets, at Deutsche Asset & Wealth Management. 

The engine behind recent moves to establish the lending of European ETFs, however, is the ETF industry. A strong lending market would boost liquidity, reduce spreads and lead to greater market adoption of the ETFs that gain momentum among securities lending participants. Once started, a virtuous circle would be created and sales of certain ETFs would soar. 

Yet the European ETF unit lending market is struggling to take off. As much as 8% of all on-loan securities in the US are ETFs; in Europe the same figure stubbornly hovers below 1% (see graph overleaf). 

Atlantic divide 

There were thousands of indications of interest (IOIs) in Q4 2014 on the EquiLend trading platform for borrowing European ETF-units, but only a handful of trades were fulfilled. Where there was ETF inventory, high fees meant that it met with lacklustre demand. 

For example, the Amundi MSCI Emerging Markets Ucits ETF, with ample supply, had an eyewatering average borrowing fee of 450bps. “That is pretty hot in the ETF space, but only 2% of the stock is on loan,” says Chris Benedict, director of DataLend, “which to me looks like a market imbalance.” 

European ETF providers are renewing their efforts to increase demand for ETFunit borrowing as well as educating agent lenders about the benefits lending would bring. 

The ETF industry in Europe now has assets under management (AuM) of $466bn in 2,095 products, according to consultancy ETFGI. Not much consolidation has occurred, especially in comparison with the US, but even so over 50 products have an AuM of greater than $1bn. 

While the concept of ETF lending in Europe is not new, it may only be now that ETFs are large and liquid enough to be considered viable instruments for lending. 

“We have talked in Europe over the last six months about ETFs being at the tipping point of growth and expansion,” says Andrew Jamieson, managing director at BlackRock iShares, who recently brought in Matthew Fowles to a newly-created role to focus exclusively on encouraging the use of ETFs in securities lending. “We are trying to be a catalyst for the expansion of the European lending landscape for ETFs, which to date has been a relative non-starter.” 

The ETF business in the US has had a substantial head start. The US ETF market is over 20 years old and has developed within a single country with a single currency, a single regulatory regime and a single depositary. Therefore, ETFs have come to be regarded as somewhat similar to individual securities and were considered to have a natural suitability to be lent, borrowed and be put up as collateral.

By comparison, the European ETF market only really got going ten years ago and operates across hugely more fragmented markets. This has led to piecemeal development of the ETF market and structural issues have led to problems with the visibility of liquidity. 

There is potential demand to borrow ETFs in Europe but at the moment it is pretty thin, according to Loic Lebrun, head of equity finance and delta one, Emea, at HSBC. Borrowing ETFs is often a more straightforward way to play a short strategy, but it is cheaper for borrowers to use alternative methods such as futures, swaps or the create-to-lend process, which is when a prime broker creates new ETF shares out of a pool of underlying securities. 

“You would expect the create-to-lend process to be far more expensive than borrowing ETF shares,” said Lebrun. “But there is not enough supply of ETFs and the supply that is there is expensive from a financing and stock borrowing perspective.” 

Availability and visibility

High pricing and erratic availability can be explained by the duel problems that agent lenders find themselves up against: the lack of ETFs in beneficial owner programmes and the visibility of liquidity. 

Availability is the biggest issue for John Arnesen, head of securities lending agency product at BNP Paribas Securities Services: “If we had exposure to ETFs we would lend them with abandon, but we simply do not seem to,” he says.

Secondly, the liquidity of ETFs is not very visible on trading screens, which drives steep pricing. BlackRock iShares estimates that as much as 60% to 80% of all ETF trades in Europe are over-thecounter (OTC). European banks are under no requirement to print OTC volumes, so they generally do not. This broadly means, unlike in the US, only on-exchange trades are visible. 

Further exacerbating the problem is that while most securities trade only in their home markets, ETFs trade on multiple venues under different tickers, making volumes difficult to aggregate. 

Robert Lees, Brown Brothers Harriman’s co-head of securities lending, Emea, explains that while his lending programme holds significant ETF inventory and he expects it to grow, liquidity as it stands means he sees no impetus to drop lending fees to below what exists in the markets. 

"There are considerations for lending those assets, including the perceived liquidity and associated pricing, so if trading desks are unable to quickly gauge liquidity through traditional methods, they are likely to price in a significant risk premium,” he says. 

“This premium does not always reflect the ETF’s constituent assets, which might actually be liquid and relatively easy to borrow. As the industry becomes more familiar with the assets and it becomes easier to accurately identify the liquidity, we would expect this pricing to become tighter.” 

While there could be a first-mover advantage for providing the supply that meets the demand, ETF lending would still not be attractive to borrowers until pricing could compete with alternative methods. Many agent lenders are aware that liquidity is far higher than what they see on their trading screens, but understandably no one is prepared to gamble on what it might be, or invest in operations to find out. 

“As we start to see an increase in demand, firms will look to develop the technology that helps them mobilise their ETFs and the market will naturally mature from its nascent beginnings,” says Lees. 

ETF providers have made attempts to make fragmented liquidity easier to aggregate. Two providers now offer ETFs with international securities structures. 

BlackRock iShares worked with Euroclear to issue the first iShares ETF with an international security structure in December 2013. State Street merged 13 SPDR ETFs into an international ETF structure in 2014. While continuing to be traded on multiple national stock exchanges, these ETFs settle in Euroclear, a single international central securities depositary (CSD), rather than settling in multiple national CSDs. 

This greatly simplifies the post-trade process, eliminating the need for depot movements. It also clarifies the visibility of liquidity and should harmonise bid-offer spreads across Europe. 

“This could potentially be a benefit to ETF lending agents. It would make it easier to assess liquidity of that ETF and therefore their ability to lend it,” said Paul Young, head of capital markets group, SPDR ETFs, Emea, at State Street Global Advisors. 

The international settlement structure is only being used by a handful of ETFs at the moment but other ETF providers are considering following suit. 

BlackRock iShares has also worked with Bloomberg to launch consolidated tape functionality for each of its funds. This allows market participants to combine all the individual ticker liquidity in each market, which while on screen on the various different venues was difficult to visualise. 

Liquidity laid bare 

Due in 2017, the Markets in Financial Instruments Directive (Mifid II) might majorly improve the visibility of ETF liquidity. The current draft of the proposals state that the pre and post-trade transparency regime for shares is being extended to cover ETFs as well as depositary receipts and certificates. This will further align ETFs with equities, requiring both the volume and price of OTC trades to be reported publically. 

“Mifid II under the current drafts states that ETFs are liquid instruments, they are equity-like instruments subject to mandatory trade reporting and it makes a lot of trading currently hidden traded volumes visible. It will make the status of the product very clear to anyone interested in buying and lending,” said Gregoire Blanc, head of capital markets at Lyxor Asset Management. 

“Will it make the operational aspects better? Not necessarily, but in principle it is definitely very helpful.” 

One major issue that Mifid II may not solve is that of availability in beneficial owners’ lending programmes. ETF providers have posited that availability is a technical, rather than actual, issue. They suggest that there is commonly miscommunication between the custody depot records and the lending desk. 

For example, ETFs could be labelled as funds rather than equities, which could mean they do not show up as available to lend. But technical issues have largely been improved by ETF providers working with data firms, says Roy Zimmerhansl, global head of securities lending at HSBC. 

However, availability is a problem that persists: "Historically the ETF investors have been retail investors so agent lenders simply do not have significant supply in their programmes. That remains a major disconnect. The biggest lenders of ETF units themselves in Europe have been Swiss banks because they have a large number of high-net-worth individuals as clients.” 

Bridging the collateral gap 

Zimmerhansl believes that most of the available ETFs in custodial lending programmes have already been mobilised and a focus on encouraging agent lenders to accept ETFs as collateral could help overall usage. He explains that prime brokers want to borrow ETFs for clients but they do not want hedge funds to buy ETFs because they cannot use it as collateral, it becomes a completely dead asset. When trying to go short the supply is often inadequate. “It is a hassle either way”. 

“The easiest change that could be made to help this project is for ETFs to be used as collateral. If I take a certain type of collateral in my underlying programme and the ETF is backed by physical stocks that match my underlying programme, it would be irrational for me not to take ETFs as collateral.” he says. 

On the broker-dealer side, Steffen Jordan, head of securities finance at SEB agrees: “A large amount of ETFs are not accepted and it is a burden on the liquidity of the market. There is a differentiation between agents looking to lend ETFs and those that will accept them as collateral. That gap has not been bridged.” 

The underlying shares of a physically-backed ETF are readily accepted as collateral. But currently, although more or less equivalent, the ETF itself is rarely accepted. This may be because of perceived complexity due to multiple listings, providers and replication methodologies (whether the ETF is synthetic or physically backed). As a consequence risk officers often do not have the wherewithal to do the necessary due diligence on a case-by-case basis. 

Trying to combat this, Blackrock iShares is working with financial participants and data providers to develop a collateral index, created and maintained by a third party that would make assessment of, and comparison between, ETFs easier. With this ETF collateral index, due diligence would be done by the third-party provider and should ensure the process is automated. In the early stages this will focus on physically- backed ETFs but there is scope to have multiple indices and add synthetic ETFs or those with a more esoteric exposure. 

ETFs might even be a better source of collateral than their underlying equites, according to Deutsche AWM’s Keshava. He notes that they have two levels of liquidity, on primary and secondary markets. So in the event it could not be sold on the secondary market, it could instead be redeemed for the underlying assets or for cash. 

“From a risk management perspective, they are also well suited due to the diversified nature of the underlying securities, which could also lead to lower volatility. Agents that take collateral need to understand that ETFs are highly suitable securities for their programme.” 

The eligible ETF 

The theory may be compelling, but agent lenders remain cautious. BNP Paribas’s Arnesen says that while his business does accept ETFs as collateral under its indemnification policy, they attract slightly higher eligibility criteria than comparable financial instruments. 

The ETF would have to track equity indices, be passively managed, have a low tracking error and the ETF provider would have to be of a certain size and have a certain percentage of its business in ETFs. Arnesen adds that spreads are again an issue. 

The difference with taking main-index equity as collateral on an open basis and ETFs (or sub-index equities) is zero, so he is not adequately compensated. On a 35-day structure the spread is about 3bps and for six months it is 5bps to 7bps. 

“In the short term there is not a lot of daylight between assets classes. This is perhaps why beneficial owners will not necessarily be that comfortable in approving ETFs as collateral. Where there is underlying investment in ETFs beneficial owners are likely to be more comfortable in approving them,” he says.

Collateral acceptability it not just an issue that impacts agent lenders says Patrick Houel, head of ETF trading in Nomura’s prime finance group. Most stock loan participants have limited appetite for ETFs as collateral. 

“As long as there is no standardised acceptability methodology for ETFs, it will remain a bespoke collateral type. Any unwanted ETF inventory will be redeemed instead of being lent as it cannot be refinanced. This in turn impacts the available borrow market pool. In short, getting ETFs to be more acceptable as collateral will be key to reducing financing costs and in turn increasing their usage.” 

Grown-up debate 

While the situation might seem to be at a deadlock the pace of development is quicker than at first glance. Market participants are fast becoming more comfortable with ETFs and are open to collaboration. 

“If you spoke to people a couple of years ago about lending ETFs, they would think you were mad for even talking about it. But now all the building blocks are coming together. As the ETF space is becoming more active and relevant, we need the ability to borrow and to finance,” said Karl von Buren, global head of equity finance and delta one at HSBC. 

The European ETF industry seems set to continue its inexorable rise. Supply of ETFs for lending will increase as potential beneficial owners increasingly use them. As spreads decrease, end users will create strategies that involve ETFs. Mifid II will arrive in 2017, alleviating many problems. 

In the meantime the securities lending market can play a role in educating their clients about the options available to them. There is no one catch-all solution to the ETF problem but goodwill on all sides will continue to push mutually advantageous answers forward. 

“We are now seeing a concerted effort to have a grown-up debate,” adds Brown Brothers Harriman’s Lees. “The industry knows ETFs have a place so it is a case of better understanding the associated opportunities.”

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