The Latest on ETFs, Securities Lending and Collateral

From Financial News, but readers beware: this article repeats some semi-accurate facts about securities lending and collateral management that perpetuate in the market. Can you spot the misleading comments? Let us know in the Leave a Reply box.

Lenders demand increased collateral to offset risk fears
Rebecca Hampson
12 Dec 2011
Exchange-traded funds have been at the centre of heated debate, with synthetic versions in particular attracting considerable criticism. But traditional ETFs are also causing concern, with worries focused on their securities lending practices.

Synthetics use derivatives such as swaps to replicate the performance of an index or benchmark while physical or traditional ETFs look to replicate an index by holding the underlying securities.

Physical or traditional ETFs often lend out the underlying stock of an index they are seeking to replicate.

In return, the borrower typically puts up collateral in the form of cash, equities, government bonds, or another agreed security. Lending has become a widely accepted practice with hedge funds, which then sell short the stock, being among the main borrowers.

While synthetics have come in for particularly fierce criticism this year about their lack of transparency and high levels of counterparty and collateral risk, the securities lending practices of physical ETF providers have also come under fire.

In April this year, for example, the Financial Stability Board warned securities lending in conventional ETFs may create similar counterparty and collateral risks to synthetic ETFs. Some synthetic providers have highlighted the risks associated with physical ETFs using securities lending.

Lending out securities helps ETF providers boost income, which in turn helps to reduce management fees and allows some mitigation of index-tracking error, meaning the borrower is able to source a complete portfolio of all the stocks in an index, which will more accurately track the performance of the index.

Stefan Kaiser, director at Blackrock, said: “The revenues investors receive from securities lending contribute to reducing the total cost of ownership. An indirect benefit from securities lending is that it supports liquidity in the securities and derivatives markets, which contributes to tighter trading spreads and therefore lowers costs for investors.”

Securities lending is often undertaken by an external custodian or, in the majority of cases, the provider does it through a dedicated internal division of the company. There are currently $1.8 trillion of global securities on loan out of a possible $12 trillion, with equities accounting for $734bn of a $6.2 trillion lendable supply. In global ETFs, only $40bn are on loan, of which the US accounts for $37bn, according to Data Explorers.

Significant risks

Alain Dubois, chairman of Lyxor, which is wholly owned by Societe Generale, warned ETFs using securities lending carry significant risks. Lyxor, as a provider of synthetic ETFs only, does not engage in securities lending. He explained securities lending carries the risk that the borrower of the securities could default and that the collateral transferred might not be sufficient to repurchase the securities.

Dubois said: “Securities lending is one part of the market that regulators haven’t even considered yet.”
Providers argue concerns about counterparty risk are being addressed, particularly in terms of how much collateral they demand from borrowers.

Blackrock’s Kaiser said: “There has been an increased focus on counterparty risk, but it’s significantly mitigated by over collateralisation, collateral liquidity and lending to a diversified set of counterparties.” He added: “Neither BlackRock, or its clients have experienced a loss in securities lending through borrower default since the programme’s inception.”

In 2008, many asset management firms and investment banks experienced significant losses related to their securities lending programmes. These losses occurred because of significant declines in the value of the securities purchased with the cash collateral. Kaiser said: “To mitigate counterparty risk we have a credit group, which is independent from the securities lending business. It reviews collateral parameters and counterparties on an ongoing basis.”

Many ETF providers also demand collateral that is more than 100% of the loaned securities’ value. iShares, a family of ETFs managed by BlackRock, typically over-collateralises by 102-105%, depending on the loan combination and primarily uses equities and government stock as collateral in its European-domiciled funds.

Policies for securities lending vary from provider to provider. While iShares lends out securities on the majority of its ETFs, Vanguard, another ETF provider, only lends out securities on a value basis – that is, when there is demand for a particular security.

Vanguard also has a collateral coverage requirement of 102% on US securities and 105% on non-US stocks, as well as over-collateralising its funds for extra security. The firm also only accepts cash as collateral.

Jeff Molitor, chief investment officer at Vanguard Europe, said: “Cash is the only thing that is safe.”

Another criticism levied at securities lending practices is the lack of transparency over revenues and fees, including how much ETF providers earn from securities lending and how these revenues are shared with investors.

Gordon Rose, ETF analyst at Morningstar, said: “The fee for securities lending depends, among other things, on the counterparty borrowing the security and the collateral they pledge in return.”

Not all providers of ETFs engaging in securities lending reinvest 100% of the funds. Some managers retain up to half the net proceeds. Also, few providers disclose what shares are on loan and what collateral assets they accept as security.

Molitor said: “The securities belong to the investor holding the fund and [he or she] should therefore get 100% of the net benefit from the securities lending programme. However, in practice there is a 50/50 split where the fund manager takes 50% of the net revenue and the rest goes back into the fund or to the investor.” He added: “It is a ‘heads I win, tails you lose’ situation. Both sides benefit during times of a bullish market. However, when the market turns bearish the loss is all on the account of the fund, so the investor takes the fall.”

Earlier this year, the European Securities and Markets Authority called for ETF providers to inform investors that they engaged securities lending and urged them to be much more transparent about their offerings. Esma called for investors to be provided with more information about fees, how they are shared, risks involved with securities lending and collateral policies.

Some firms have already responded. iShares, for example, moved towards improving transparency in September when it started disclosing the details of its securities lending activities on a daily basis online.

• How much profit is ploughed back into ETFs?

The percentage of revenues generated by securities lending and then returned to the fund varies among European ETF providers. Managers can often retain up to half of the net proceeds, while others return 100% back to the fund.

However, it is not always clear how the gains from securities lending are shared, and has prompted queries in the market on why all net revenues from securities lending are not returned to the fund, given that the fund’s investors are ultimately responsible for any potential losses.

ComStage, the ETF arm of Commerzbank, returns 100% of the revenues generated from securities lending back to the fund, while Vanguard also returns 100% of revenues generated after subtracting costs and fees.

Blackrock’s iShares returns 60% of all net revenues from securities lending back into the fund. Kaiser said: “Blackrock covers all of its operational costs out of its 40% share.”

SPDR ETF, part of State Street, returns 50% of gross revenues from its securities lending back into the fund, meaning that the other 50% of revenues generated cover costs from the lending agent. However, State Street does not employ securities lending in all of its ETFs.

Eleanor Hope-Bell, vice-president at SPDR, said: “We lend out securities on some of our European ETFs, mainly the French-domiciled SPDR ETFs. However on others we do not because it would be tax disadvantageous to do so.”

The lack of clarity around the practice has prompted a transparency drive from some providers to disclose more information on securities lending, including collateral used and revenues generated from the practice.

In September, Blackrock’s iShares started disclosing the details of its securities lending activities within its physical replication funds on a daily basis online. State Street is also planning to build out its website to include additional information and educational materials around its securities lending programme.

The original article is here.

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