How do ETF markets in the US and Canada differ?
I think that they differ quite measurably. Obviously, one is the size difference between Canada and the US. The US is a $1.4 trillion AUM market space and we’re $56.4 billion. Even the number of products offered is worth comparing: 1442 in the US, and 268 here. The number of participants are significantly different too; we have eight here in Canada, and then there are nearly 50 in the US.
How exchange-traded funds (ETFs) operate in the US is a little bit different. One of the things that they have that we don’t—and we’d like to get there—is an indicative optimised portfolio value agent (IOPV); their role is really to price and publish the ETF basket, and provide pricing every 15 seconds. If I’m an investor, I can easily use the ETFs ticker followed by .V, see what the indicative price is, and compare it to what the market is showing.
Here in Canada, we don’t have a similar operation to the NSCC, which is the clearinghouse for ETFs on behalf of DTC. This can create some operational challenges when it comes to asset delivery; overall the process works generally the same way, but we just don’t have a centralised clearinghouse that is specifically for the ETFs.
From a structural perspective, ETFs in the US can have a few different types of structures. They can be registered investment companies or unit trusts, they can be granted trusts, master limited partnerships, exchange-traded notes, and so on. In Canada, we do have exchange-traded notes, but all other ETFs are structured as unit trusts, and so its fairly simplistic from that perspective.
Would there be any scope to diversify?
I don’t think the regulators are looking to make the market any different than it is currently. It works well and the regulations mirror those for Canadian mutual funds, which is helpful for investors, as most of our retail mutual funds are usually structured as unit trusts as well. We do have retail mutual funds that can be structured as mutual fund corporations, but those aren’t available to be ETFs.
I can’t see the regulators changing their minds on the regulatory structure. Our unit trusts are very similar to those in the US in that aspect, but we have a little more flexibility. The reason there are so many variations in the US is that most of them are regulatory, you’ve got the 1933 act (the first major federal legislation to regulate the offer and sale of securities) and the 1940 act. In Canada, you can be a unit trust ETF, a commodity ETF, an Index ETF or an actively-managed ETF, and you can do that all within a unit trust structure.
Another thing that a lot of people don’t realise is that the transparency that is mandated in the US, where they’re providing NAV, closing market prices to the ETFs, the basket itself and the components in the basket, isn’t a legal requirement in Canada. That doesn’t mean that ETF providers in Canada aren’t providing that information, it’s just not a regulated requirement to do so. Canada does have regulations requiring issuer reporting on a quarterly basis, as well as on a semi-annual basis, but we don’t currently have a regulation saying that you must disclose your full portfolio on a daily basis. That’s a big difference between Canada and the US.
How important is securities lending to an ETF earning more basis points?
Securities lending is not going to be a material change to an ETF’s earnings, but it is a very good source of risk-adjusted returns—a low-risk option that many ETFs are choosing because it can help earn a few additional basis points. You can’t really generalise the amount of revenue from lending because it depends on the composition and characteristics of the firm’s portfolio as well as the lending programme choices that each fund makes.
Why were ETFs excluded from securities lending in Canada?
They were and they weren’t. In 2007, there was legislation to allow qualified unit trusts to be lent, and it basically said in very simplistic terms that a Canadian resident mutual fund trust that is listed on an exchange could be lent.
That was great for Canadian ETFs that were unit trusts, and we’d been lending those types of assets for a number of years. The one thing that came out in the latest change was that it no longer needs to be a Canadian resident unit trust. Any unit trusts, regardless of which country it’s from, if it is exchange-traded product and it’s a unit trust, it can be lent. So that’s some good news.
The problem is that the majority of the US ETFs are not unit trusts, which still effectively excludes them from lending: they are legally lendable, but securities lending transactions are treated like dispositions and acquisitions rather than loans, which can create substantial operational and tax barriers. You have a few products—the triple Qs, the spiders, the diamonds—that are structured as unit trusts, so those can be lent without the same challenges.
CIBC Mellon was recently selected to provide Horizons ETFs with securities lending—why are securities lending services bundled, and what are the advantages of this?
Consolidating custody and securities lending services with one provider can definitely create operational efficiencies for ETFs. Whether it’s Horizons or any other ETF sponsor, its an economy of scale, having similar processes, building a relationship with your service provider and just knowing that they have a partner that will help with both solutions and issues—you’re dealing with one vendor that can deal with those for you. Of course, the strength of the lending provider is an important consideration, so ETF sponsors considering consolidation must do their due diligence to ensure that their custodian is also a good lending agent.
To what extent do bundled services suit the ETF product?
They suit them very well. Having a more than one service provider probably increases your cost in some ways, and may increase risk, for example, if there’s a breakdown in communication with one of the other parties, it could delay a transaction. Clients that bundle securities lending with custody can also realise cost and flexibility advantages over a third-party platform—consider a situation when a security needs to be called back from loan. A client with a third-party lender would need to call the security back, there would have to be a transaction—which adds time and costs—and then it would be back into our custody platform. Bundling lending and custody consolidates the securities on a single system: the client calls its provider and we pull it back into its custody account. In addition to the savings on transactional cost, faster response times can help clients mitigate risks in a fluid market.
Canada is considered to be a safe environment in which to do business—how else is the country looking to open up its ETF market that will maintain this while making it more attractive?
Canada has a very strong financial history, with a banking system that is probably the safest in the whole world. We have very strong regulations when it comes to mutual funds. Here in Canada, ETFs are regulated in the same way as mutual funds: heavy, with a lot of oversight. There’s a lot of comfort in ETFs and how they’re regulated here, and that should give comfort both to Canadians retail investors and large institutions. As an industry, there are improvements being made—specifically, the Canadian ETF Association (CETFA) has a goal to provide information, education and access to resources on ETF investing in Canada. That is to be the knowledge source for everything ETF in Canada. CETFA has a media and public relations committee, which provides the financial sector and the public with insights and updates on recent developments concerning ETFs; a policy committee, that reviews any changes in legislation that may affect ETFs; and an operations committee (that I vice-chair) that looks at how we can improve overall operational efficiencies and ensure any new regulations will work from operational point of view.
← Previous interview
CACEIS Group
Guy Knepper
Next interview →
eSecLending
Peter Bassler
Image: Shutterstock 
