Since ETFs are a costlier proposition than traditional index-tracking funds, institutional investors considering them as the core in a core-satellite asset allocation model are usually advised to engage in securities lending to offset the costs. However, in practice, stock borrowers will go where there is greatest liquidity and transparency, and the European market is hindered by different tax regimes and a multiplicity of trading and settlement platforms, with some exchanges still national institutions that trade only local, country-specific stocks.
“It is possible to offset total expense ratios on ETFs via securities lending of ETFs. The ETF securities lending market in the US is relatively well established,” says Daniel Draper, head of Lyxor ETFs UK, Ireland and the Nordic region. “There are investors with long-term investment horizons, such as pensions, who benefit from lending out their ETFs, and there are hedge funds with short-term investment horizons who benefit from borrowing ETFs in order to implement their various short strategies. Europe, on the other hand, is a different story. At the moment Europe suffers from fragmentation at various structural levels, including settlement and clearing systems, making it significantly more expensive to match up ETF borrows and lenders when compared to the US.
“European hedge fund managers therefore use ETFs in the US for their shorting activities. For the European market to compete, greater transparency is required but the prime brokerage leaders are reluctant to do anything to this end because the more transparency there is, the more securities lending becomes commoditised.”
In the US, where the $9.9bn SPDR fund has just celebrated its 15th birthday, greater liquidity and homogenous settlement systems have encouraged ETF short interest to double over the past year, albeit on a similar level of growth in ETF assets under management, says Deborah Fuhr, managing director at Morgan Stanley. December 2007 short interest level for US-listed ETFs was 15.9 per cent of shares outstanding or 1393m shares, up 49.9 per cent from 929m in December 2006. “It is largely an historical accident,” she says. “The US market doesn’t have sector futures so historically ETFs were one of the few products that investors could use to short a sector. Until last July, shorting ETFs was also a way round the uptick rule, a major historical factor that prevented US investors selling short stocks that were falling in value. ETFs on the entire spectrum of emerging markets are also of interest as these markets are otherwise difficult to short. The advent of new products that embrace shorting, such as in 130/30 funds, will also cause groups to begin to look at securities lending in a more positive light.”
The M&A effect
One structural reason that securities lending is on average less profitable in Europe is that the UK, arguably the region’s epicentre, is dominated by a few large-capitalisation stocks that typically have not traded ‘special’ in recent years in the absence of M&A speculation.
Roy Zimmerhansl, who is managing Icap’s foray into the electronic securities lending market, says that when his team researched the market they discovered that securities lending in the ETF trading arena has different characteristics. “Generally, if a stock is in demand because a hedge fund or proprietary trader needs it, the odds are many [borrowers] will be looking at the same trade,” says Mr Zimmerhansl. “If it is not widely available, it will drive up the rate and any stock will get snapped up. For these ‘special’ stocks, where there is less availability even if someone can find the stock to borrow, they won’t all execute the trade on the same day. If a lender gets new supply and rings up the next day, the broker is still likely to want the stock. ETF trading is different in that if the requirement doesn’t get satisfied immediately it tends to go away. Demand is more individually-driven and that customer will have a particular need at a particular time that may not be shared by other customers. For instance, it may be a structured trade and if that bank can’t provide the stock then the hedge won’t happen at all. This is very different from arbitrage strategies or M&A, where a pending transaction may be out there for weeks on end.”
London still has certain advantages over the US, such as its historical willingness to take securities as collateral rather than cash, so avoiding the need for cash management. “It is a different model stemming from US legislation on eligible collateral for Erisa plans,” says Hugh Gibson, a spokesman for the International Securities Lending Association. “To be able to take securities makes the work a great deal easier.”
Triparty agent business in Europe has also grown markedly in the last five to 10 years, so individual parties don’t have to manage their collateral and become embroiled in the differences of the settlement and tax systems. Mr Gibson is confident that triparty services will be made acceptable for Ireland-domiciled Ucits next month, which should be a particular boost to ETF stock lending in the region.
The market currently has few trading tools, spread across the phone, email, instant messaging and some order routing platforms. Icap’s new electronic platform improves traders’ access to securities borrowing and enhances revenue generation through efficient inventory distribution. The system is being piloted live with 10 users and another five, at various stages of development, are due to go live by March.
