Securities industry veterans Roy Zimmerhansl and Andrew Howieson have published a white paper calling for structural changes in the European ETF market to facilitate the more widespread lending of fund shares.
A more active securities lending market in ETFs, say Zimmerhansl and Howieson, will provide a critical boost to the secondary market liquidity of European ETFs. The liquidity of European ETFs in secondary trading is currently significantly below that of the US ETF market.
Investors would also benefit from more widespread securities finance activity in ETFs, say the authors.
“Currently European investors take a double hit when using ETFs,” said Roy Zimmerhansl at a press conference in London on Monday to mark the publication of the white paper, ‘ETF Liquidity, Securities Finance and Collateral Management’.
“The inability to lend ETFs means that investors pay higher bid-offer spreads in the secondary market, as well as missing out on the potential lending revenues when holding them,” said Zimmerhansl.
Zimmerhansl and Howieson stressed that their research should be seen as having a different objective to that of the recent UCITS/ETF guidelines issued by the European securities regulator, ESMA.
“[Our] focus…is on the trading and operational mechanics related to the lending, borrowing and financing of ETFs, which are separate and distinct from the issues that receive attention in the ESMA paper,” say the authors.
From a securities finance perspective, ESMA’s guidelines paid particular attention to the balance between risk and reward when ETF managers lend out shares from their funds’ portfolios. ESMA also requested that fund investors receive of all the income associated with securities lending, net of any costs incurred by the manager or its lending agent.
The ways in which ETFs and the securities finance market interact are complex, say Zimmerhansl and Howieson, and fall into six broad categories, which the authors spell out in the white paper.
First, say the authors, there’s the lending of the underlying securities from an ETF using physical replication (owning the securities of the index being tracked). This practice, the focus of ESMA in its recent guidelines on UCITS, is broadly accepted and “used to offset the relatively high replication costs and tracking errors inherent in physical replication ETFs,” say the white paper’s authors.
Second, note Zimmerhansl and Howieson, there’s lending from the substitute basket held by a synthetic (derivatives-based) ETF. This, however, say the authors, is not a widely accepted practice, since securities that are in demand in the securities finance market are unlikely to find their way into ETFs’ substitute baskets.
The third area of overlap between European ETFs and securities finance—lending from a basket of pledged collateral in an ETF following the so-called funded (or prepaid) swap model—should in theory be prohibited as the collateral is held either in the name of the ETF issuer or in the name of the swap counterparty, under pledge to the ETF issuer. In either case, say Zimmerhansl and Howieson, the collateral should not be available for lending as under standard pledge arrangements the assets remain under the ownership of the pledging counterparty.
