Unlocking liquidity and stability: The benefits of using fixed income ETFs as collateral
03 September 2024
The use of fixed income ETFs as collateral represents an enormous opportunity for the financing markets, says Matthew Chessum, director of securities finance at S&P Global Market Intelligence
Image: stock.adobe.com/ZeNDaY
Exchange traded funds (ETFs) continue to gain popularity among both investors and institutions across the global financial ecosystem. As the securities lending and repo markets continue to evolve, these instruments offer unique benefits to borrowers and lenders, not just as lendable assets, but also as sources of collateral.
According to S&P Global Market Intelligence ETF data, fixed income ETFs currently account for approximately 22 per cent of the entire ETF market, in terms of assets under management (AUM). The creation of both passive and active fixed income ETFs is a growing trend within the ETF industry, and this percentage is expected to grow substantially over the next two to five years.
As fixed income ETFs are more aligned with the traditional asset classes used for collateral purposes (notably government bonds and other types of high-quality liquid assets), the use of fixed income ETFs as collateral represents an enormous opportunity for the financing markets.
As a result, a growing number of institutions are now accepting fixed income ETFs as collateral. S&P Global Market intelligence shows that the value of ETF collateral balances has grown approximately 35 per cent over the last four years.
Using fixed income ETFs as collateral
One of the primary benefits of using fixed income ETFs as collateral is their liquidity. Fixed income ETFs are typically more liquid than individual bonds, especially in secondary markets where trading volumes of specific bonds can be low. This liquidity makes ETFs a more attractive and versatile option for collateral, enabling faster and more efficient transactions.
Another significant advantage is diversification. Fixed income ETFs often hold a basket of bonds, spreading risk across multiple issuers and sectors. This diversification reduces the exposure to any single issuer's credit risk, which can be a concern when using individual bonds as collateral. For collateral takers, this means a lower probability of a significant loss if a single bond issuer defaults.
Market innovations, such as S&P Global Market Intelligence ETF collateral lists, also offer full transparency into these assets. The ETF collateral list product uses ETF data to bring transparency, efficiency, and automation when selecting ETFs to be included in collateral management programmes.
Collateral receivers can customise parameters to suit their organisation’s risk profiles and mandates to screen the universe for ETFs that meet their eligibility standards. A collateral receiver can therefore receive daily updates on their holdings, allowing both parties in a collateralised transaction to have clear visibility into the underlying assets. This transparency builds trust and reduces uncertainty, particularly during times of market stress.
Common challenges
Despite their benefits, using fixed income ETFs as collateral can present some challenges. One issue is price volatility. While ETFs are generally liquid, their market prices can still be subject to significant fluctuations, especially during periods of financial instability.
This volatility can complicate collateral valuation and may require more frequent margin calls to maintain appropriate collateral levels. This potential issue is usually offset by using higher levels of margin when posting the assets.
Another concern is tracking error. Passive fixed income ETFs are designed to replicate the performance of a bond index, but they do not always do so perfectly. Factors such as fees, rebalancing, and market conditions can cause the ETF’s performance to diverge from the underlying index. This discrepancy may introduce additional risk for the collateral taker, who might not be fully compensated if the ETF underperforms relative to the assets it is supposed to represent.
By ensuring that the asset is regularly priced while displaying sufficient levels of market liquidity, as any collateral taker normally would with their other acceptable assets, this issue can be effectively managed.
Opportunities
Despite these challenges, there are growing opportunities for using fixed income ETFs as collateral.
ETF AUM by asset class (as a % of total AUM)
Regulatory changes and market evolution are pushing for more standardised and efficient collateral management practices. As regulators demand higher-quality collateral, fixed income ETFs, especially those with high-grade bond holdings, are likely to see increased demand.
Moreover, the development of new ETF structures and enhanced liquidity provisions could mitigate some of the current issues. For example, the rise of actively managed fixed income ETFs, which aim to outperform their benchmarks, could offer more stable returns and lower tracking errors, making them more attractive as collateral.
Lastly, the growing acceptance of ETFs in collateral frameworks by central banks and clearing houses provides a significant opportunity. As these institutions begin to accept ETFs more broadly, the role of fixed income ETFs as collateral is likely to expand, offering new avenues for financial institutions to optimise their collateral portfolios.
With the ongoing market developments and regulatory changes, fixed income ETFs hold significant potential as a mainstream collateral type, paving the way for more innovative and efficient collateral management strategies in the financial markets. This will benefit the entire securities finance ecosystem as the importance of collateral flexibility continues to grow.
According to S&P Global Market Intelligence ETF data, fixed income ETFs currently account for approximately 22 per cent of the entire ETF market, in terms of assets under management (AUM). The creation of both passive and active fixed income ETFs is a growing trend within the ETF industry, and this percentage is expected to grow substantially over the next two to five years.
As fixed income ETFs are more aligned with the traditional asset classes used for collateral purposes (notably government bonds and other types of high-quality liquid assets), the use of fixed income ETFs as collateral represents an enormous opportunity for the financing markets.
As a result, a growing number of institutions are now accepting fixed income ETFs as collateral. S&P Global Market intelligence shows that the value of ETF collateral balances has grown approximately 35 per cent over the last four years.
Using fixed income ETFs as collateral
One of the primary benefits of using fixed income ETFs as collateral is their liquidity. Fixed income ETFs are typically more liquid than individual bonds, especially in secondary markets where trading volumes of specific bonds can be low. This liquidity makes ETFs a more attractive and versatile option for collateral, enabling faster and more efficient transactions.
Another significant advantage is diversification. Fixed income ETFs often hold a basket of bonds, spreading risk across multiple issuers and sectors. This diversification reduces the exposure to any single issuer's credit risk, which can be a concern when using individual bonds as collateral. For collateral takers, this means a lower probability of a significant loss if a single bond issuer defaults.
Market innovations, such as S&P Global Market Intelligence ETF collateral lists, also offer full transparency into these assets. The ETF collateral list product uses ETF data to bring transparency, efficiency, and automation when selecting ETFs to be included in collateral management programmes.
Collateral receivers can customise parameters to suit their organisation’s risk profiles and mandates to screen the universe for ETFs that meet their eligibility standards. A collateral receiver can therefore receive daily updates on their holdings, allowing both parties in a collateralised transaction to have clear visibility into the underlying assets. This transparency builds trust and reduces uncertainty, particularly during times of market stress.
Common challenges
Despite their benefits, using fixed income ETFs as collateral can present some challenges. One issue is price volatility. While ETFs are generally liquid, their market prices can still be subject to significant fluctuations, especially during periods of financial instability.
This volatility can complicate collateral valuation and may require more frequent margin calls to maintain appropriate collateral levels. This potential issue is usually offset by using higher levels of margin when posting the assets.
Another concern is tracking error. Passive fixed income ETFs are designed to replicate the performance of a bond index, but they do not always do so perfectly. Factors such as fees, rebalancing, and market conditions can cause the ETF’s performance to diverge from the underlying index. This discrepancy may introduce additional risk for the collateral taker, who might not be fully compensated if the ETF underperforms relative to the assets it is supposed to represent.
By ensuring that the asset is regularly priced while displaying sufficient levels of market liquidity, as any collateral taker normally would with their other acceptable assets, this issue can be effectively managed.
Opportunities
Despite these challenges, there are growing opportunities for using fixed income ETFs as collateral.
ETF AUM by asset class (as a % of total AUM)
Regulatory changes and market evolution are pushing for more standardised and efficient collateral management practices. As regulators demand higher-quality collateral, fixed income ETFs, especially those with high-grade bond holdings, are likely to see increased demand.
Moreover, the development of new ETF structures and enhanced liquidity provisions could mitigate some of the current issues. For example, the rise of actively managed fixed income ETFs, which aim to outperform their benchmarks, could offer more stable returns and lower tracking errors, making them more attractive as collateral.
Lastly, the growing acceptance of ETFs in collateral frameworks by central banks and clearing houses provides a significant opportunity. As these institutions begin to accept ETFs more broadly, the role of fixed income ETFs as collateral is likely to expand, offering new avenues for financial institutions to optimise their collateral portfolios.
With the ongoing market developments and regulatory changes, fixed income ETFs hold significant potential as a mainstream collateral type, paving the way for more innovative and efficient collateral management strategies in the financial markets. This will benefit the entire securities finance ecosystem as the importance of collateral flexibility continues to grow.
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