The mainstream press appears to have confused some of the opportunities and risks surrounding ETFs in securities lending. In fact, there are multiple activities occurring when ETFs are lent, or ETF sponsors lend securities themselves, each of which is a separate activity that warrants evaluation. It is a particular concern that while specialist publications may understand the story, more broadly read periodicals may not grasp the same level of detail. As the Financial Stability Board and others continue to evaluate securities lending and ETFs, this article seeks to separate the important issues and provide clarity on risks and rewards.
The First Issue: Lending the ETF Itself
When ETFs are loaned, the lender can only be the actual owner of the security itself. There appears to be a belief that an ETF sponsor will lend its own ETF. This is possible although ETF sponsors are not the dominant lenders of ETFs. Rather, that honor goes to pension plans, insurance companies, mutual funds and other large investment groups. Some ETF companies do lend out their own securities but they does not appear to have a dominant share of the market.
The Second Issue: Lending from a Basket of Physical Underlyings
Only ETF sponsors that have something to lend can engage in securities lending if they so choose. ETF sponsors with physical underlyings hold a trust of securities for each ETF in the market; no physical ETF unit can exist without these securities for potential redemption requests. While holding these assets in trust, the ETF sponsor can lend securities just as a mutual fund or pension plan might. While this may yield little for an S&P 500 fund, returns could be meaningful for a Russell 2000 index ETF. Derivative-based ETFs can lend the collateral they hold against their swap baskets.
Securities lending can offer important returns to ETF sponsors particularly when broader market indices are lagging. An analysis of the last year of returns for twelve major ETFs shows that all engaged in securities lending, and that securities lending earned the funds between 0.3 and 11 basis points against AUM. As a percentage of total income earned, securities lending contributed between 0.39% to 9.66% to these ETFs. As some funds lend while others do not, participation in securities lending offers market participants a choice about the risk and returns that they want to accept in their investments.
The Third Issue: Lending Securities from a Basket of Collateral in a Derivative-backed ETF
ETFs lending securities out of a derivatives basket is different than ETFs holding physical assets lending out of a trust. In the derivatives model, the ETF does not itself own what it is lending; rather it is taking advantage of a pledge in order to create additional returns. Derivative-based ETFs have an additional step to return the original cash pool to the investor. ETFs with physical underlyings are lending securities they hold in trust. In the event of a run, it is easier for these ETFs to recapture their securities and sell them for cash to meet investor redemptions. While derivative-based ETF providers may argue that they offer no additional investor risk, it is important to highlight the subtle but important differences in the ETF investment process, and what consequences this may bring in the event of a future market disruption.
In practice the value of lending securities from a collateral pool can vary. db X-trackers does engage in this practice although returns are certainly modest; there are no broad-based hard to borrow pools among these STOXX 50 and European government debt issues.
As ETFs continue to grow, we see a potential for increased risk in financial markets from derivative-based ETFs lending securities, but the dangerous scenario we see would require a much broader run on equity or commodity markets than on ETFs by themselves. In the event of a sudden run in ETF redemptions, derivative-based ETFs lending securities would be forced to recall their securities promptly or engage in buy-ins to return assets to their collateral pools. They would then return collateral to their swap provider in exchange for cash to return to the investor. These processes will be complicated or simplified by other conditions that market participants are experiencing.
We do not see an inherent conflict in derivative-based ETFs engaging in securities lending programs with their underlying collateral so long as the ETF maintains a liquidity buffer for investor redemptions. If ETFs maintain a certain amount of cash in their portfolios or can access the cash quickly through their swap agreements, then our concerns are mitigated. However, ETFs that lend heavy amounts of swap-based collateral and cannot access cash quickly appear to be in a comprised position.
The Fourth Issue: The Risk of a Run on the Market
If many ETFs suffer a run of redemptions all at once and all must recall securities at the same time, this would not only produce a short squeeze but would also likely create a series of other disruptions in risk management and hedging for hedge funds, market makers, options and futures traders. At this point the market would be likely evaluating a large-scale loss with ETFs as only one component.
However, a true ETF run on the market can only happen if ETFs are redeemed en masse and all ETF sponsors lend the securities they hold in trust. It also presumes that ETFs represent a major portion of securities lenders relative to other mutual funds, pension plans and insurance companies This is not the case, as ETF lenders are both small relative to the overall market and several major ETF sponsors do not lend their securities at all. In fact, ETFs hold a total of US$1.6 trillion AUM compared to US$16 trillion in total lendable assets, or 10%, and some ETF sponsors do not lend some or all of their funds. The FSB’s comment in this area hints of hyperbole.
As the press evaluates regulatory and other comments on ETFs in securities lending, it should carefully understand the different mechanics in place for each activity and evaluate the risks independently. To mix the issues together creates the illusion of greater potential problems than actually exist.
For more information, Finadium published a recent report on ETFs in securities lending and collateral management. The press release is here.