Last week, I addressed some of the points raised in a recent Financial Stability Board (FSB) report on potential risks arising from “recent trends” in the ETF space. The first trend in question – the use of synthetic ETF models in some regions of the world – was the topic of my last post. This week I’d like to tackle concerns about the practice of securities lending in ETFs.
I think a quick explanation of securities lending is in order. First of all, sec lending is far from exclusive to ETFs – in fact it’s a common strategy engaged in by institutional investors and funds, wherein they temporarily transfer a security that they own to another investor or financial intermediary in exchange for collateral (cash or securities). Funds participate in securities lending because investors can benefit from the revenue generated. Essentially, revenue earned by lending securities in the fund is reflected in the fund’s net asset value (NAV).
In the case of ETFs, there are two levels of securities lending. First, institutional investors are able to lend out their own shares of an ETF; and second, the ETF itself can lend shares of the underlying securities in the fund. The first example is the one being referenced in numerous blog posts and articles as something that could cause a “short squeeze” in an ETF. Since this is a different issue than what was raised in the FSB report, I’ll be addressing it in a separate, upcoming blog post (stay tuned).
Instead I want to focus on the latter example, where the ETF is actually lending out the underlying securities of the fund. The FSB report takes issue with this practice, implying that a fund would abuse securities lending in order to generate more fee income, thus causing additional counterparty and collateral risks. Here’s my take on this: as with all investments, you can’t eliminate risk from all aspects of an investment program. At our firm, we believe it makes sense to provide a risk-managed securities lending program as a benefit to shareholders. As such, we utilize a dedicated group within BlackRock that’s independent from our Securities Lending team to manage counterparty selection, credit limits, eligible collateral, and levels of over-collateralization. This risk management framework has resulted in no losses as a result of a borrower default since the program’s inception in 1981.
The report also states that “a prevalence of securities lending could create a risk of a market squeeze in the underlying securities” when large-scale fund redemptions occur. It should be noted that this is not an ETF issue – the same thing could occur in all other fund structures. That being said, the 1940 Act, which governs the majority of physical ETFs in the US, dictates that a fund cannot lend more then one third of its total asset value. Getting back to the large-scale redemption concerns, it should be noted that the loaned securities can be recalled at anytime. Furthermore, the cash collateral is invested by the ETF in money market funds that have liquidity and holdings parameters regulated by the SEC with a primary objective of providing liquidity to investors.
As with the synthetic ETF issues I addressed in my last post, I’d like to stress that I think these are fair points to raise – in fact, I’m a proponent of more education so that investors can better understand these somewhat sophisticated concepts and “know what they own” when investing in ETFs. I want to stress in these blog posts a sense of balance. The issues raised by these reports look at the extremes and ignore many measures that are already in place to prevent the problems they’re theorizing about. If people let the hype overshadow the facts, then we run the parallel risk of diluting what has been a benefit to investors for years.
Next up: a response to the short squeeze debate as it relates to the lending of ETFs themselves.
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