The market for exchange-traded funds (ETFs) has skyrocketed over the past quarter-century, thanks to the trillions of dollars investors are put¬ting to work in passive, index-tracking strategies. What hasn’t yet exploded is the use of ETFs backing securities financing arrangements and loans.
Clients of BNY Mellon were pledging and receiving $26 billion of ETFs daily as of late July, up from a low of $14 billion four years ago but down from highs of nearly $38 billion at the start of 2018. The share those funds represent of overall equity collateral balances at BNY Mellon has barely budged, hovering around 4% of equity collateral and just 0.7% of total collateral.
Many participants say this could change, if participants can overcome their early skepticism toward ETFs and regulators can allow more favorable terms between those pledging and receiving collateral — at least for fixed income ETFs containing securities that can be easily converted to cash.
Several signs point to a wider adoption of ETF collateral, even though some on the front lines are not currently pushing it. Some buy-side firms that previously rejected ETFs are now warming up to receiving them against securities loans and repurchase agreements, also known as repos, where their risk committees will allow.
At the same time, there is a growing interest on the part of some lenders and brokers to pledge fixed income ETFs rather than other assets in their inventory. There is also an opinion, on the part of some traders, that regulators might one day allow ETFs full of short-dated Treasury bills to be counted as high-quality liquid assets (HQLA) for regulatory collateral pur¬poses. This could increase the demand for fixed-income ETFs in general.
Proponents say the more ETFs are mobilized as collateral, the more it will increase the funds’ liquidity and reduce market friction. Additionally, for those jurisdictions and credit arrangements where cash collateral may be restricted, ETFs could be easier to move and manage than other assets. BNY Mellon looks at four categories as part of this discussion: the background, the arguments for ETF collateral, the roadblocks, and a path forward.