The global ETF industry
The global exchange traded fund (ETF) industry has seen phenomenal growth over the past few years. The first ETF was created, listed and traded in North America in 1993 and ETFs have since gathered significant assets in the US. At the end of Q3 2010, there were 890 ETFs listed in the US from 29 providers on two exchanges, with total assets under management standing at $797.2 billion.
In Europe, ETFs are 10 years old and there is evidence that the market is growing at a similar rate and in a similar fashion to what we have seen in the US. The European market is more fragmented given the variety of countries and financial jurisdiction spanned, and at the end of Q3 2010, there were 1,030 individual ETFs from 37 providers on 21 exchanges, with industry assets totalling $256.2 billion.
Investors in both regions, and indeed throughout the world, have used ETFs to gain access to markets in an efficient and precise way. ETFs track the performance of a given index, be that related to equity, fixed income or even commodity or real estate. They are simple to use and fees are commonly lower than those charged by active mutual funds. Since they trade on-exchange, ETFs can be also bought and sold throughout the day and pricing is updated continually, so investors can receive an accurate idea of the value of their holdings at any time.
ETFs and the capital
markets
As the ETF market has developed, ETFs have begun to play an increasingly important role in today’s capital markets. For example, several ETFs such as the iShares FTSE 100 fund are amongst the most traded instruments on the London Stock Exchange on any given day.
ETFs investors can benefit from the lending of underlying constituents of the ETFs and also lending of ETF units themselves. And more widely, securities lending in ETFs improves liquidity in the securities and derivatives markets, allows investors to express negative views on equities as well as positive ones and enables market-makers to provide an efficient two-way pricing mechanism to the market.
As ETFs in Europe have gradually moved into the mainstream investment universe, we have seen increased activity in ETF units lending activity in the region. However, the market has not yet reached the same scale and maturity as it has done in the US, which still represents the bulk of ETF lending activity, despite the efforts of lenders, brokers and other market participants to provide liquidity to the market to meet demand.
On-loan values in the top five European funds represent under two per cent of the funds’ assets under management (AUM). In the US, the top five funds have on-loan values in excess of 15 per cent of assets under management, and borrowers are able to benefit from lower lending rates. This is a consequence of the fact that ETFs are a newer and younger product set here, but also indicates how the market could potentially expand.
Indeed, the market now appears to be gaining pace rapidly, with lenders seeing a considerable increase in demand over the last 12-18 months. Data Explorers, an independent aggregator and vendor of securities lending pricing and volume information, has observed that European ETF lending in the past year has increased by 149 per cent in dollar terms. In addition, the fact that on-loan values represent a high percentage of lendable values confirms that demand is strong and that there is an active lending market for ETF units, as shown in the table below.
ETFs and securities
lending: how it works
There are two main aspects to the way in which securities lending benefits ETF investors. In the first instance, the ETF’s investment manager can lend the constituent parts of an ETF and a portion of the revenue that this generates is returned to the fund. This activity, common in many unit trusts or mutual funds available to the public, accrues benefits to all fund shareholders as reflected in the fund’s Net Asset Value (NAV).
Secondly, large shareholders can lend their iShares units, which is something that investors in other pooled fund vehicles cannot do. Each individual holder decides whether or not to lend their units, and any lending revenue accrues directly to that investor.
Higher lending fees in some European funds offer the ETF unit holder, otherwise known as the beneficial owner, opportunities for significant revenue generation, especially in funds which track illiquid or difficult to access markets.
From an operational perspective, the lending of the ETF units is a simple process. ETFs trade and settle like equities. There are commonly four key participants in the process: the beneficial owner, the two intermediaries that facilitate the matching of supply and demand in the market place, and the borrower.
Contractually, the transaction usually consists of a temporary transfer of an ETF unit to a borrower, with the lender retaining full economic entitlement to the units, such as distribution payments.
ETFs and securities
lending: what you
need to know
Since 2008 we have seen an unprecedented financial crisis with the failure of several key institutions. As a result of these events, some investors have been cautious about or refrained from making their holdings available via a lending programme because of concerns around counterparty risk, and whether the other party is able to complete on the transaction.
It is vital that investors carry out due diligence before entering into a lending programme with any of their securities. There are always risks involved but the lending agent or custodian will be able to provide information on how such risks are actively managed and controlled. For example, borrowers may be selected on the basis of how well-capitalised they are. The transaction may be fully collateralised with only highly rated collateral accepted, revalued on a daily basis and taken at a value that is greater than the loan value. Collateral is also commonly held in a tri-party escrow or custodian account that is ringfenced from the provider’s balance sheet. There will be procedures and provisions for unexpected market conditions. In addition, the beneficial owner should ensure that they are aware of how the lending revenue is split between the owner and the agent.
In a bid to increase the supply of units and facilitate lending and borrowing, there are now matching services which put lenders and borrowers in contact with one another, enabling them to familiarise themselves and transact with counterparties active in the ETF space.
In liquid names, where the underlying securities are cheap to borrow, supply is being increased by lenders via “create-to-lend” transactions. This process involves the lender borrowing the constituents of the fund and using these to create ETF units for the sole purpose of lending them to the borrower. This type of transaction has enabled a number of investors to source inventory at competitive rates in a market where these units were otherwise unavailable. This is a result of borrow costs being based on the weighted average cost to borrow the fund constituents rather than the supply and demand of the ETF itself.
ETFs as collateral
Within the lending market, another area in which ETFs can play an active role is as a form of collateral.
Until recently, this subject is one that has provoked mixed opinion. There has been some lack of understanding of how ETFs are structured and how liquid they are. On the other hand, there is enthusiasm from some market participants who consider ETFs a better form of collateral than others.
Using single stocks, lenders often determine haircuts based on a fully weighted basket of an index. As index constituents have different weightings within the index, large amounts of collateral can be pledged from less liquid names within an index and this can potentially result in difficulty liquidating. Accepting an ETF with a physical structure however provides an underlying weighting equivalent to the index and assures larger weightings in the liquid securities.
Also in challenging market conditions, the nature of an ETF and the fact that in itself, it offers diversified exposure to a spread of stocks within an index, means that its volatility should be lower than a concentrated basket of securities.
Finally, the open-ended structure of ETFs allows for the possibility to liquidate in the primary market, via an authorised participant, and in the secondary market should the need arise.
The future of securities lending and ETFs
The simplicity, flexibility and cost advantages of ETFs mean that they offer numerous possibilities and uses within the lending market. Priority has to be given to improving the supply in the market, which directly impacts the ability of investors to execute their trading strategies efficiently. Similarly, borrowing ETFs can be a competitive hedging solution relative to using futures or OTC derivatives. For all these reasons, there may be borrowing demand for many ETFs in various market conditions.
Current market data also demonstrates how the lending of ETF units is a growing component of the securities lending market. According to Data Explorers, there were over €12 billion in ETF units on-loan as at the end at end April 2010. Based on ETF growth, these figures are likely to grow as will the importance of this security within the lending space as a whole.
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