ETFs firmly on the ground
20 March 2018
As ETFs establish themselves in the securities lending market, industry players suggest that there is the potential for strong growth
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As exchange-traded funds (ETFs) establish a firm footing in the securities lending market, market participants suggest that there is a potential for strong growth, especially as the European market continues to lag behind its US counterpart. However, lenders need to be sure that demand exists and would-be borrowers need to know that liquidity exists.
ETFs are bundles of securities such as stocks or bonds that track an index and can be traded on an exchange. They aim to provide investors with diversified access to specific markets.
For investors, ETFs have two potential sources of revenue from securities lending activities. Firstly, lending of the individual securities that make up the ETF—the proceeds of which aim to benefit fund holders in the form of tighter tracking to the benchmark index. Secondly, whole ETF units can be lent, providing the owner with the potential to earn additional income. Lending ETF units are no different to lending individual equities or bonds, as it is a transferable security.
Mohamed M’Rabti, Deputy Head of FundsPlace, Euroclear, said: “Market-makers say they want to lend, but there is no pool, while agent lenders say they want to lend, but there is no demand.”
He suggested that the chicken and the egg in the ETF securities lending world is the equivalent to demand and supply.
Beyond the anecdotal, there is mounting hard evidence that ETFs continue their inexorable rise. Matt Fowles of the iShares Europe, the Middle East and Africa (EMEA) capital markets team at BlackRock, explains: “Figures from IHS Markit show that European ETF availability for lending has risen dramatically, up by around 80 percent in the last two years.”
He adds: “The US ETF borrow market provides a useful lens on the direction of travel for Europe, as we develop into a well-established market where ETFs are regularly used to hedge portfolios.”
Samuel Pierson, analyst at IHS Markit, agrees. Pierson suggests: “Flows into ETFs have contributed to the increasing supply for securities lending, which recently moved past $20 trillion globally.”
Pierson says: “The lending of underlying shares is meaningful and securities lending revenues have increased,” he adds. “The revenue generated by lending ETFs and their constituents have played a meaningful role in the trend toward lower fees for passive index products.”
According to M’Rabti, securities lending involving ETFs “will increase in Europe”.
He explains: “Currently in the US market, around 15 percent of the lendable pool is lent. The equivalent figure in Europe is just 5 percent.”
One driving force is a result of Euroclear’s work to reduce fragmentation in Europe by internationalising settlement into a single location, at Euroclear. M’Rabti says: “If you buy in one market, sell in another and need to deliver in a third, you incur higher costs and experience inefficiency.”
“Adopting the international model delivers economies of scale which reduces costs and increases efficiency.” He calculates that around 35 percent of total ETFs outstanding in Europe have already converted to the international model.
Another form of utility ETFs bring to the securities lending ecosystem is in the form of collateral. Jamila Jeffcoate, head of agency lending, EMEA at State Street Global Markets, says that ETFs have been an acceptable form of collateral in State Street’s agency lending programme since 2012. “Our borrowers put forward suggestions as to the ETFs they would like to pledge and we review those requests on a case by case basis,” she says.
Jeffcoate adds: “We follow a rule of thumb regarding eligible criteria as opposed to a set in stone approach but we take geographic focus, market cap and liquidity into account as well as setting a minimum price threshold for each ETF we take in.”
There are benefits both for lenders and for borrowers, she says. “Being able to provide an expansive collateral profile across all asset types has obvious benefits to the agency programme,” she continues. “In terms of lenders, it provides additional opportunities for increased utilisation and enhanced returns. On the borrower side, it presents a cost-efficient way to pledge securities that are available as part of their prime businesses. We are adding to our eligible inventory for ETFs all the time, but the supply in European ETFs is still relatively thin compared to the US.”
Simon Heath, head of agency trading for EMEA, State Street Global Markets, explains: “Clients are broadly increasing the amount of ETFs they hold, and the more they hold, the more they will naturally find their way into securities lending programmes.”
Another driving force is increased in visible liquidity, thanks to the transparency delivered by the requirement imposed by the second Markets in Financial Instruments Directive (MiFID II) to report over-the-counter trading.
M’Rabtie also suggests that European interest in ETF unit lending will over time lead to a change in emphasis from the current operational focus on covering settlement fails and towards a more strategic long-term investment view, following in the footsteps of established specialist investors such as hedge funds.
According to Fowles, we are already experiencing this in Europe with borrower demand showing strong signs of evolving beyond traditional market maker activity. “We hear increasingly from hedge funds looking to use ETFs as efficient hedging tools and recently witnessed our Euro High Yield ETF (according to IHS Markit data) hit record on loan balances of $450 million as investors adopt a hedging tool for their portfolios.”
ETFGI, an independent research and consultancy firm on trends in the global ETF/exchange-traded products (ETPs) ecosystem, recently reported that February 2018 marked 49 consecutive months of net inflows into ETPs listed globally.
The growth of ETFs is fuelling a surge in securities lending markets, according to IHS Markit in its Q3 2017 report. On average, there was 29 percent more ETF holdings in lending programmes over the quarter than Q3 2016. This surge in inventory, which has vastly outpaced the industry’s assets under management growth, speaks to the increased adoption of ETFs among institutional investors, who provide a large part of the securities lending inventory.
Although inventories are rising sharply, demand and revenues remain concentrated, indicating there is still some way to go before ETFs become the go-to tool for actively traded markets. Increased interest on both sides of the equation, supply and demand, feed each other, says Fowles. “More demand will drive more revenues for investors, which in turn will provide more data and further demand from clients to lend. This is a classic virtuous circle.”
For those uncertain whether to lend or not, the financial consideration could sway the decision one way or another. In an educational note published in July 2017, IHS Markit waxed lyrical about the possibilities for future ETF securities lending development, pointing to the revenue opportunities that exist. The ETF securities lending debate has largely revolved around what IHS Markit labels inside lending, where ETF issuers lend out the underlying assets purchased to replicate their chosen benchmark. What investors have historically been less aware of are the increasing opportunities and benefits from lending out the ETF units themselves, or “outside lending”.
In several cases revenues from such outside lending, which is the prerogative of an ETF’s ultimate beneficial owner, vastly outweigh those earned from the type of lending most commonly associated with the asset class.
In its treatise, IHS Markit identifies several ETF borrow demand dynamics. The forces driving demand to borrow physical ETF units are numerous, but the most common reasons include investors wishing to hedge assets tracked by an ETF, market making activity in the funds themselves, and the growing lists of derivatives that
track them.
IHS Markit notes that although ETFs have been around for over two decades now, the asset class is still relatively underrepresented in the securities lending market, especially Europe, which means that the growing pool of investors looking to borrow ETFs often struggle to get their hands on the most in-demand lines. A quarter of the 2,200 ETFs that feature inside lending programmes have over half their inventory out on loan.
The combination of the constant demand for ETFs and the relatively high fees which can be drawn from this demand means that global ETF investors earned over $167 million from lending out ETFs over the last 12 months. This represents a return of 11.6 basis points on the ETF assets that are available in lending programmes over this period. As with the rest of the securities lending market, the bounty earned from lending out ETFs is unevenly distributed, with the 10 largest revenue-generating funds amassing one-third of all revenues.
For all the positive talk, much work remains to be done, cautions Euroclear’s M’Rabti. It is important to continue to educate the market, he says, adding that Euroclear’s annual collateral conference, industry papers, occasional roundtables and participation in industry working groups will help to achieve that goal.
ETFs are bundles of securities such as stocks or bonds that track an index and can be traded on an exchange. They aim to provide investors with diversified access to specific markets.
For investors, ETFs have two potential sources of revenue from securities lending activities. Firstly, lending of the individual securities that make up the ETF—the proceeds of which aim to benefit fund holders in the form of tighter tracking to the benchmark index. Secondly, whole ETF units can be lent, providing the owner with the potential to earn additional income. Lending ETF units are no different to lending individual equities or bonds, as it is a transferable security.
Mohamed M’Rabti, Deputy Head of FundsPlace, Euroclear, said: “Market-makers say they want to lend, but there is no pool, while agent lenders say they want to lend, but there is no demand.”
He suggested that the chicken and the egg in the ETF securities lending world is the equivalent to demand and supply.
Beyond the anecdotal, there is mounting hard evidence that ETFs continue their inexorable rise. Matt Fowles of the iShares Europe, the Middle East and Africa (EMEA) capital markets team at BlackRock, explains: “Figures from IHS Markit show that European ETF availability for lending has risen dramatically, up by around 80 percent in the last two years.”
He adds: “The US ETF borrow market provides a useful lens on the direction of travel for Europe, as we develop into a well-established market where ETFs are regularly used to hedge portfolios.”
Samuel Pierson, analyst at IHS Markit, agrees. Pierson suggests: “Flows into ETFs have contributed to the increasing supply for securities lending, which recently moved past $20 trillion globally.”
Pierson says: “The lending of underlying shares is meaningful and securities lending revenues have increased,” he adds. “The revenue generated by lending ETFs and their constituents have played a meaningful role in the trend toward lower fees for passive index products.”
According to M’Rabti, securities lending involving ETFs “will increase in Europe”.
He explains: “Currently in the US market, around 15 percent of the lendable pool is lent. The equivalent figure in Europe is just 5 percent.”
One driving force is a result of Euroclear’s work to reduce fragmentation in Europe by internationalising settlement into a single location, at Euroclear. M’Rabti says: “If you buy in one market, sell in another and need to deliver in a third, you incur higher costs and experience inefficiency.”
“Adopting the international model delivers economies of scale which reduces costs and increases efficiency.” He calculates that around 35 percent of total ETFs outstanding in Europe have already converted to the international model.
Another form of utility ETFs bring to the securities lending ecosystem is in the form of collateral. Jamila Jeffcoate, head of agency lending, EMEA at State Street Global Markets, says that ETFs have been an acceptable form of collateral in State Street’s agency lending programme since 2012. “Our borrowers put forward suggestions as to the ETFs they would like to pledge and we review those requests on a case by case basis,” she says.
Jeffcoate adds: “We follow a rule of thumb regarding eligible criteria as opposed to a set in stone approach but we take geographic focus, market cap and liquidity into account as well as setting a minimum price threshold for each ETF we take in.”
There are benefits both for lenders and for borrowers, she says. “Being able to provide an expansive collateral profile across all asset types has obvious benefits to the agency programme,” she continues. “In terms of lenders, it provides additional opportunities for increased utilisation and enhanced returns. On the borrower side, it presents a cost-efficient way to pledge securities that are available as part of their prime businesses. We are adding to our eligible inventory for ETFs all the time, but the supply in European ETFs is still relatively thin compared to the US.”
Simon Heath, head of agency trading for EMEA, State Street Global Markets, explains: “Clients are broadly increasing the amount of ETFs they hold, and the more they hold, the more they will naturally find their way into securities lending programmes.”
Another driving force is increased in visible liquidity, thanks to the transparency delivered by the requirement imposed by the second Markets in Financial Instruments Directive (MiFID II) to report over-the-counter trading.
M’Rabtie also suggests that European interest in ETF unit lending will over time lead to a change in emphasis from the current operational focus on covering settlement fails and towards a more strategic long-term investment view, following in the footsteps of established specialist investors such as hedge funds.
According to Fowles, we are already experiencing this in Europe with borrower demand showing strong signs of evolving beyond traditional market maker activity. “We hear increasingly from hedge funds looking to use ETFs as efficient hedging tools and recently witnessed our Euro High Yield ETF (according to IHS Markit data) hit record on loan balances of $450 million as investors adopt a hedging tool for their portfolios.”
ETFGI, an independent research and consultancy firm on trends in the global ETF/exchange-traded products (ETPs) ecosystem, recently reported that February 2018 marked 49 consecutive months of net inflows into ETPs listed globally.
The growth of ETFs is fuelling a surge in securities lending markets, according to IHS Markit in its Q3 2017 report. On average, there was 29 percent more ETF holdings in lending programmes over the quarter than Q3 2016. This surge in inventory, which has vastly outpaced the industry’s assets under management growth, speaks to the increased adoption of ETFs among institutional investors, who provide a large part of the securities lending inventory.
Although inventories are rising sharply, demand and revenues remain concentrated, indicating there is still some way to go before ETFs become the go-to tool for actively traded markets. Increased interest on both sides of the equation, supply and demand, feed each other, says Fowles. “More demand will drive more revenues for investors, which in turn will provide more data and further demand from clients to lend. This is a classic virtuous circle.”
For those uncertain whether to lend or not, the financial consideration could sway the decision one way or another. In an educational note published in July 2017, IHS Markit waxed lyrical about the possibilities for future ETF securities lending development, pointing to the revenue opportunities that exist. The ETF securities lending debate has largely revolved around what IHS Markit labels inside lending, where ETF issuers lend out the underlying assets purchased to replicate their chosen benchmark. What investors have historically been less aware of are the increasing opportunities and benefits from lending out the ETF units themselves, or “outside lending”.
In several cases revenues from such outside lending, which is the prerogative of an ETF’s ultimate beneficial owner, vastly outweigh those earned from the type of lending most commonly associated with the asset class.
In its treatise, IHS Markit identifies several ETF borrow demand dynamics. The forces driving demand to borrow physical ETF units are numerous, but the most common reasons include investors wishing to hedge assets tracked by an ETF, market making activity in the funds themselves, and the growing lists of derivatives that
track them.
IHS Markit notes that although ETFs have been around for over two decades now, the asset class is still relatively underrepresented in the securities lending market, especially Europe, which means that the growing pool of investors looking to borrow ETFs often struggle to get their hands on the most in-demand lines. A quarter of the 2,200 ETFs that feature inside lending programmes have over half their inventory out on loan.
The combination of the constant demand for ETFs and the relatively high fees which can be drawn from this demand means that global ETF investors earned over $167 million from lending out ETFs over the last 12 months. This represents a return of 11.6 basis points on the ETF assets that are available in lending programmes over this period. As with the rest of the securities lending market, the bounty earned from lending out ETFs is unevenly distributed, with the 10 largest revenue-generating funds amassing one-third of all revenues.
For all the positive talk, much work remains to be done, cautions Euroclear’s M’Rabti. It is important to continue to educate the market, he says, adding that Euroclear’s annual collateral conference, industry papers, occasional roundtables and participation in industry working groups will help to achieve that goal.
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