A whitepaper examining the key issues involved with secondary market liquidity of European ETFs has been launched to debunk the pre-, and in some cases misconceptions around transparency in the lending of these instruments.
The lack of development in securities lending is a major factor in the relative illiquidity of European ETF markets, the whitepaper finds. As such, one of its primary objectives is to recommend changes to market practice with the potential to remove barriers to the development of securities lending and collateral management in relation to European listed ETFs. It finds that more trading opportunities could be unlocked through securities lending and makes recommendations for change at both an individual firm level as well as for the industry as a whole.
The whitepaper, authored by Roy Zimmerhansl of FinTuition and Andrew Howieson of Howieson Consulting, is based on interviews with study sponsors (ABN Amro Clearing, BNY Mellon, Clearstream, iShares, Northern Trust, SIG Susquehanna and Xetra), and other key market participants as well as on original research and review of the extensive range of analyses and commentaries relevant to the ETF markets. In June, Zimmerhansl and Howieson launched a survey on the current use of European ETFs in securities financing as part of a wider study on the subject.
Essentially, the study finds lending underlying securities from a physical replication ETF is an established market practice, however, it is the lending of ETF shares which impacts the liquidity of ETF markets.
The review finds that the application of current industry standard measurement fails to recognize the characteristics of ETFs and inappropriately restricts the availability of ETFs to lend. Similarly, European ETFs are generally not accepted as collateral. Restrictions include: liquidity and diversification requirements which are inappropriate in the case of ETFs and merit reconsideration; arbitrary rejection of synthetic ETFs as collateral, based on transparency concerns; and the inconsistent application of the equivalent asset test so that underlying securities are accepted as collateral when a (diversified) ETF is rejected.
The whitepaper notes that liquidity in ETF markets is frequently regarded as questionable by potential investors, based on limited trading volumes displayed on-screen by the listing exchanges. It also notes that, while displaying some of the characteristics of listed equities such as transparency and continuous market-maker pricing, ETFs also display unique trading characteristics. As a result, trading takes place in both the Primary (create and redeem) market and the Secondary (On-exchange and Over The Counter OTC) market.
Industry statistics support the widely held view that European listed ETFs are relatively illiquid in comparison to US listed ETFs, says the whitepaper. According to the BlackRock ETF Landscape June 2012, Average Daily Volume (ADV) for European listed ETFs for the month of June was $2.9 billion (2.3 billion) with AUM of $273.0 billion (215.5 billion). This equates to an ADV/AUM ratio of 1.09%. In contrast, ADV for US listed ETFs for the same period is reported as $52.6 billion (41.5 billion) with AUM of $1,056.6 billion (834.1 billion), generating an ADV/AUM ratio of 4.98% for US listed ETFs. By this measure, US listed ETFs are more than 4.5 times more liquid than European listed ETFs.
The second principal driver of relatively low liquidity in European listed ETFs is the lack of a developed securities lending market in ETF shares, adversely affecting the ability to short sell European ETFs. In turn, difficulty in shorting European listed ETFs discourages market participation from hedge funds who wish to gain either long or short exposure to market segments.
Looking at European listed ETFs and securities lending, the research identifies several areas of the impact on securities finance:
– Lending underlying securities from a physical replication ETF; lending underlying securities follows standard securities lending practice for UCITS funds including over-collateralization, daily mark to market of both collateral and securities on loan and (potentially) provision of an indemnification from the lending agent. Lending from a substitute basket in a synthetic ETF, the substitute basket securities are not defined as collateral (although they are required to comply with UCITS rules). While securities deposited in substitute baskets are required to meet UCITS standards in terms of eligibility, liquidity and diversification, swap counterparties are unlikely to deposit securities with a high or potentially high level of demand for securities finance purposes
Zimmerhansl and Howieson write that they not aware of any evidence that collateral held under funded swap transactions is made available for lending purposes. In common with physical replication and unfunded swap structure ETFs, investors in funded swap structure ETFs have the opportunity to lend ETF shares
– Lending ETF shares: The process for lending ETF shares is fundamentally the same as that for lending other securities from investment portfolios. Lending is usually conducted through agent lenders (custodian banks or third party agents) representing the lenders and prime brokers representing hedge funds (end borrowers) or investment banks acting on a principal basis. First, on the supply side a series of factors influence ETF lending including the fact that investors are not always aware that ETFs offer lending opportunities. Second, from the demand side, prime brokers tend to discourage hedge funds use of European listed ETFs. On the short side this is due to the limited availability of European listed ETFs to borrow and on-lend to their hedge fund clients. As a result of prime brokers reluctance or inability to source supply of European listed ETFs in support of short strategies or to finance long positions, hedge funds are restricted in their use of European listed ETFs as investment tools
Despite these issues and constraints, it is clear that lending opportunities exist. The whitepaper cites data from Equilends AutoBorrow, which captures borrower shorts, European ETF borrow requests for the first half of 2012. It can be seen there were more than 10,000 borrow requests each month except June (9,197); and the number of different ETFs requested ranged from 165 227 per month. Further, even in June, the lowest month, 80 different ETFs had more than 30 borrow requests in the month. This is significant in that it means there is more than one borrower looking for that security. 29 issues all had more than 100 borrow requests with the top 3 securities having more than 300 requests each.
As with lending ETF shares, the use of create to lend is limited in Europe compared to the US. The creation/redemption process is also the basis for create to lend, whereby APs create (or redeem) ETF creation units with the specific intent of lending ETF shares.
Restrictions on European ETFs as collateral include liquidity and diversification requirements, which are inappropriate in the case of ETFs and merit reconsideration. The equivalent asset test is not consistently applied, so that underlying securities are accepted as collateral when a (diversified) ETF is rejected. Synthetic ETFs are arbitrarily rejected as collateral, based on transparency concerns. European ETFs are not adequately classified, requiring evaluation on a case-by-case basis. ETFs offer significant advantages as collateral instruments, meriting a more objective evaluation of collateral acceptance criteria.
The authors recommend the following individual changes:
– increasing the use of ETFs as collateral by adopting an internally approved (Equivalent Asset Test) and providing additional remedies through the cascading effect that are not available for cash market equities and bonds;
– increase the lending of ETF shares themselves if the lender is actively lending European ETFs, it needs to ensure that its clients have reviewed and approved ETFs (if appropriate). If not, commence due diligence. The whitepaper also suggests building up the supply of high loan-fee paying ETFs available through low-cost processing methods should increase the ability for traders to implement short-related trading strategies, reinforcing the demand cycle;
-build supply through third-party lending mandates. However, the authors caveat this in in terms of the need for low cost per-loan processing. This would seem a particular challenge in the absence of predictable longer term borrowing demand.
-Finally they suggest that create to lend activity will increase opportunistically for some firms and recommend better usage of transient long positions through the market maker and investment bank community;- increased borrowing demand for ETFs Hedge funds, market makers and other proprietary traders are currently limited by the lack of supply of European ETFs available for loan.
In addition, the authors also make the following industry action recommendations:
-establish an industry classification system supported by ETF Issuers;
-define best practice for lending ETFs, addressing liquidity and diversification standards appropriate to ETFs;
-define best practice for acceptance of ETFs as collateral. Consistency with securities lending best practice is integral to this effort; accordingly, we recommend that agent lenders and cash equity repo lenders take the initiative in consultation with tri-party providers, potentially working through ISLA or through a separate initiative.
-Janet Du Chenne