There have been a couple articles on Exchange Traded Funds — ETFs — recently. We are starting to see to a common theme.
The four articles are:
- “Bond ETFs aren’t cheap to borrow, finds Markit”, Securities Lending Times, May 23, 2014
- “UBS sets 50% limit on ETF securities lending”, Investment Week, May 27, 2014
- “Checking out of the ETF hotel could be costly”, Financial Times, May 23, 2014 (sorry, behind the pay wall)
- “BlackRock’s Fink says leveraged ETFs could ‘blow up’ whole industry”, Reuters Hedgeworld, May 28, 2014
ETFs are indexed to an underlying stock, bond, or portfolio. The neat thing about ETFs is that “authorized participants” will allow creation of more ETFs by delivering the underlying assets or unwinding by asking for the underlying assets be delivered. When the cost to borrow or lend the underlying assets is put into the mix, there can be arbitrage opportunities.
Beyond that, the actual ETFs can be borrowed or lent. Say the ETF is very difficult to borrow and fees very high. By borrowing the underlying assets, a trader could then deliver them against the ETF and then lend that ETF out. As long as the cost to borrow the components is lower than the fee earned to lend out the EFT, there could be some money in there. Of course there may be some friction preventing everything from being perfect, but with some scale and good sec lending sources, it can work. (At least until higher capital rules take their bite….) And EFTs themselves may be a leverage pool of assets — with all the risk that borrowing against (sometimes) less than liquid assets bring.
From the SLT article:
“…Markit analyst Andrew Laird charted the top 20 most expensive-to-borrow ETFs, with the top six including Vanguard Intermediate Term Corporate Bond ETF and Market Vectors Emerging Markets Local Currency Bond ETF…”
If the fixed income ETFs are hard to borrow, that tells something about the ease (or lack thereof) for borrowing the underlying paper (and visa versa). We wonder if the repo and/or sec lending market bears this out?
In the Investment Week article, the author writes about UBS deciding to only lend out a maximum of 50% of the underlying paper behind any ETF. The EFT sponsor has to have the paper to back the issue and generate the return, but there has been nothing stopping them from lending the paper out. In fact, the lending fees are often where all the juice is on the ETF. There has been pressure on the ETFs to be transparent about how much is lent out, but it is something of a tempest in a teapot. As long as there is cash collateral conservatively invested, good operational controls, and maybe indemnities from the sec lenders, it shouldn’t go pear shaped.
“…Andrew Walsh, head of UBS ETF UK & Ireland, said: “In recent years, only one ETF had lent out just slightly more than 50% of its underlying equities, and that was for a very short space of time.
“Nevertheless, to provide our clients with greater peace of mind, we have decided to formally limit securities lending for all UBS equity ETFs to a maximum of 50%.”…”
It seems like the 50% limit isn’t really binding anyway and more for optics. Nevertheless, should demand for the underlying paper rise and the 50% cap become meaningful, things could change.
We did note the final sentence of the article:
“…UBS only permits securities lending on physically replicated equity ETFs and there is no securities lending on fixed income and precious metal ETFs…”
We wonder why they don’t lend the fixed income underlying out? Is it often illiquid and hard to get back? It isn’t much of a stretch to connect the dots to the Securities Lending Times article.
The FT article: They admit to channeling the Eagles and Hotel California using the quote “”You can check out any time you like, but you can never leave.” The author says that ETF liquidity isn’t always that great. In stressed environments a few funds have suspended redemptions — the process of exchanging the ETF for the underlying assets. The examples given are from high yield fixed income — a market known for episodic liquidity under the best of circumstances. When the ETF is used for liquidity that isn’t there in the underlying assets, eventually there are bound to be problems. Perhaps the right analogy is to the conservation of energy? How do you create liquidity in the derivative that fundamentally isn’t there in the underlying? The answer is: you might do it for short periods, but not in the long run.
From the article:
“…Every investor should be factoring in a potential illiquidity premium when they are thinking about purchasing less liquid assets such as corporate bonds where, for a variety of reasons, the secondary market is now a shadow of what it once was…And yet it is doubtful whether that is being done in the case of ETFs, whose allure is largely predicated on the promise of a cheap and never-ending stream of liquidity that happens behind Wall Street’s closed doors…”
In the Reuters Hedgeworld article, BlackRock head Larry Fink said, while on a panel with Deutsche Bank co-CEO Anchu Jain:
“…We’d never do one (a leveraged ETF),” Fink said at Deutsche Bank investment conference in New York. “They have a structural problem that could blow up the whole industry one day…”
Leverages ETFs are synthetic structures which typically include a swap that generates the leveraged return. The swap provider does a total return swap (asset return goes one way, financing cost goes the other) with the ETF creating a return that is, say, 2 or 3 times the ETF’s notional. The TRS provider can hedge by buying the underlying asset notional x the leverage factor, then financing it themselves. The ETF return can be volatile — in both directions — and, as Fink said, could blow up the business one day. This, of course, differs from the leverage in ETFs that come when they lend out their underlying securities and reinvest the cash — although regulators who complain that securities lending is a form of shadow banking might beg to differ.