The European Securities and Markets Authority (ESMA) has this week released securities lending guidelines for ETFs.
Industry consensus is that ESMA believes securities lending involving ETFs does not pose significant threats to liquidity that is a major selling point of the products, as previously feared by regulators, but that better labeling is required. It is also calling for securities lending transactions to be of no fixed duration.
Financial Security Board (FSB) wrote in a caution on ETFs’ financial stability in April 2011 that some ETF providers are said to generate more fee income from securities lending than from their traditional management fees. It added that greater reliance on lending could heighten counterparty and collateral risks. The FSB showed special concern for synthetic ETFs; while only a small market (according to Celent, European-listed synthetic exchange traded products in January through October 2011 were only $1.25 billion of around $28.1 billion of new inflows recorded), extensive lending from these portfolios could bring additional complexity and leverage, exposing not only ETF investors, but also the banks and asset managers that devise and manage them, to heightened liquidity risk during stressed markets. Also of concern were the potential effects during concerted requests for redemption of a particular ETF or widespread market stress. Calling in large amounts of shares of those most frequently lent could create market squeezes of their own.
In its guidelines, ESMA called for the following:
– Inform investors of the intention to use ETF securities lending and collateral management. This involves a description of the risks involved in the activities, including counterparty risk and potential conflicts of interests.
– The collateral posted by the relevant third party to mitigate counterparty risk should be sufficiently diversified in order at any time the portfolio composed of assets not subject to the technique complies with the UCITS diversification rules.
-The UCITS should have in place a clear haircut policy for each asset class of assets received as collateral. This policy should be documented and should justify each decision to apply a specific haircut, or to refrain from applying any haircut to a certain class of assets.
-The UCITS annual report should also contain details of the underlying exposure obtained through securities lending techniques, identity of the counterparties to these techniques and the type of collateral received by the UCITS to reduce counterparty exposure.
Commenting on the guidelines, Steven Maijoor, chairman of ESMA, said: In outlining the draft future rules for investment funds, Esma is proposing to reinforce the legal framework applicable to ETFs and other types of UCITS.
The aim of these guidelines is to enhance investor protection and limit the risk of certain practices by strengthening, in particular, the standards applicable to collateral received in the context of activities such as securities lending.
Moreover, the proposed guidelines improve the quality of the information provided to investors to allow them to make informed investment decisions.
Furthermore, the draft guidelines help address concerns arising from the increase in the number of complex products sold to retail investors and will contribute to the convergence of the regulatory framework for these products.
Writing in a blog following the release of the regulations, DataExplorers Will Duff-Gordon says: I get a sense that, as a result of doing a deep dive into each area, ESMA are tentatively concluding that there is nothing hugely wrong with current practices aside from the need for better labeling. This must come as a relief to the ETF industry.
In a separate development, European regulators and legislators have once again failed to reach an agreement on key legislation designed to overhaul OTC derivatives markets.
A key sticking point for completing the high level text of the European market infrastructure directive (EMIR) remains the role that the European Securities and Markets Authority (ESMA) would have in resolving disputes that may arise between national regulators in terms of central counterparty (CCP) authorization.
ESMA is the regions securities watchdog that will also be responsible for drafting the technical details for EMIR. The deadline for technical standards is the end of June 2012 but many industry participants have doubted whether this deadline will be met, given the holdup in the trialogue debates.
CCP authorization has plagued trialogue meetings between the European Parliament, the Council of the European Union and the European Commission since December last year. Michel Barnier, the European commissioner for internal market and services had said last week that he was confident today’s meeting would be the last and anticipated the finalization of the high level text by Easter.
– Janet Du Chenne (Global Custodian) reporting on the ESMA guidelines; Anish Puaar (The Trade) reporting on the EMIR CCP delays