European ETFs And Securities Lending

If the ETF market's phenomenal growth can be attributed to the typical fund's ability to offer low-cost access to a diversified pool of securities, then the ability to do this rests on quite complicated underlying mechanics. That includes, of course, the in-kind creation/redemption process, which involves the fund provider and a series of market makers/Authorised Participants, and contributes greatly to the overall low costs of ETF portfolios.

No less important in keeping ETF costs competitive and the secondary market liquid is the securities lending process, both within ETFs and at the fund level. Securities lending is the flip side of the short sale market. The way it works is simple. In order to sell shares in an ETF or a stock short, an investor must first "borrow" them from another shareholder. The borrower typically pays a fee to the shareholder loaning the shares. This fee varies based on the scarcity of the loaned security: A commonly held share can be borrowed for very little, while a more esoteric security (or a security that a lot of people are trying to sell short) may cost more. Lending securities can be a very lucrative endeavour for investors.

In the ETF world, there are two kinds of securities lending that take place: securities lending within an ETF and securities lending of ETFs. Within an ETF, the ETF sponsor can loan out shares of the underlying stocks held by the ETF, e.g., a FTSE 100 ETF could loan shares of the underlying FTSE 100 components. These fees can be (but are not always) used to augment the total return of the fund.

The lending of ETF shares themselves is completely different, offering ETF shareholders the chance to profit from their funds in an important way.

In this article, I concentrate on lending of ETFs, rather than the income from the lending of funds' underlying securities (i.e., lending within ETFs), a subject I hope to refer to in a future article.

One of the major differences between the U.S. and European ETF markets is the extent to which securities lending is much less developed as an activity in Europe than across the Atlantic. The charts below, provided by the London-based securities finance specialists, Data Explorers, show the average percentage utilisation (i.e., the proportion of the available supply of ETFs on loan at any given time) in the U.S. and Europe respectively. Note the different y-axis scales in the two charts.

So while in the U.S. nearly half of the available supply of ETFs is typically on loan at any time, in Europe the percentage has been in single figures, and recently in the low single figures.

Data Explorers also provided figures for the percentage on loan of the largest 10 European equity ETFs, taking a snapshot a couple of weeks ago, and they found that only two of the top 10 had lending levels above 1%—the Lyxor and BGI versions of the DJ Euro Stoxx 50 ETF, at 3% and 1%, respectively.

Why is this? What accounts for the relatively low lending activity in Europe? After all, it is frequently pointed out by market observers that ETF lending revenues can frequently cover the total expense ratio, making the investment effectively cost-free.

Donato Cianciaruso and Stefan Kaiser of iShares, the leading European ETF provider, and one of the most active lenders of securities worldwide (both as iShares and in the guise of their parent company, BGI), gave me several reasons when I asked them this question.

First, said Cianciaruso, one must take into account that the European ETF market is at an earlier stage of development than the U.S. market, and that Europe is not a single region, either from the perspective of the issuer or from that of the investor. For example, iShares typically lists ETFs in six or seven European countries, each with different legal and tax regimes. If owners of assets are taxed at different rates in different European countries, then it may be impossible to quote a single European loan rate for individual securities.

Second, the European custody market is relatively fragmented, and many ETFs in the region are not available to loan for the reason that they have simply not been allocated to the lendable pool of securities by their custodians.

Third, other mechanisms for obtaining short exposure to an index or sector in Europe have up to now been highly competitive with physical shorting. The index and sector swap markets, for example, which developed earlier in Europe than ETFs, are still the preferred route for many long/short investors.

Fourth, there are some quite simple operational inefficiencies in the European market. For example, European securities lending has traditionally operated at the level of ISIN numbers, which are different for the different country listings of individual ETFs. So, often, stock borrowers do not look through to the underlying ETF, and demand to borrow a particular fund that may not be matched with available supply because of different identifying codes.

Greater Involvement Of Hedge Funds

Roy Zimmerhansl, head of Electronic Securities Lending at ICAP in London, reinforced several of these points when I spoke to him recently at his office near Liverpool Street. He highlighted the far greater involvement of hedge funds in the U.S. ETF market—when compared to Europe, something that drives demand for borrowing in the U.S. and contributes to the consistently high utilisation figures that are evident in the chart above from Data Explorers. As a result, said Zimmerhansl, the bid/offer spreads quoted for ETF lending are much more clearly defined in the American market than in Europe, where traders are often unsure how to price a particular ETF loan, and simple arbitrage opportunities frequently occur. To give an example, at the recent launch of the iSEC electronic securities lending platform in London, the indicative rates quoted by six different lenders for the iShares Xinhua 25 ETF ranged from 10-20 basis points to 550-600 basis points!

Of course such inefficiencies attract capital, and in the European ETF market there are several specialist intermediaries acting as principals and taking long and short positions, and trading ETFs against futures, swaps and the constituent securities. Indeed, such firms provide much of the existing market liquidity and securities lending activity.

Zimmerhansl also noted that the multiple ETF market listings, which are so typical in Europe, reduce secondary trading liquidity and contribute to frequent mismatches between borrowers and lenders. At his estimate, those wishing to borrow ETFs in Europe are often lucky if they can source more than 30% of the desired amount from available lenders.

He added that, up to now, securities lending revenues haven't made a meaningful contribution to lenders and dealers, causing a chicken-and-egg situation where there hasn't been an industrywide push to promote lending activity. The dramatic growth in European ETF investment levels, said Zimmerhansl, hasn't been matched yet by the ability to trade actively and support the secondary market. As a result, in his view, the ETF issuers' marketing pitch—including the ability to short ETFs like an equity, and to earn additional revenue from lending an ETF's underlying holdings—is more representative of the potential opportunity than the current trading environment.

I made this observation to Kaiser of iShares, who conceded that ETF lending levels in Europe had up to now remained very modest, but he said that things are beginning to change. In the case of iShares, he pointed out that five of their firm's non-U.S. ETFs now typically have over $100 million on loan—the DJ EURO STOXX 50, the FTSE 250, the Dax, the FTSE 100 and the Xinhua 25 China fund.

Will lending levels increase? At the level of market infrastructure, ICAP has recently launched an electronic platform for ETF lending in an attempt to provide better liquidity and transparency to market participants. Zimmerhansl points out that European securities lending has traditionally taken place using a network of rather inefficient bilateral contacts (a lot of phone calls and Bloomberg messages), whereas the ICAP system is designed to provide a single platform to those firms that already have the necessary credit and counterparty approvals. With 14 firms now signed up, including the major European issuers, ICAP is hoping that the critical mass will be reached to shift European lending activity to a higher level. He sees a common interest for his firm and for ETF managers in achieving this, as all would like to see secondary market liquidity increase.

While Zimmerhansl doesn't expect an immediate ramp in lending figures—he describes his firm's strategy as a "build it and wait" model—he says he is encouraged by the number of users using the ETF section of iSEC, ICAP's electronic lending platform.

In the opinion of Cianciaruso and Kaiser of iShares, the prerequisites for a jump in European ETF lending activity also include a consolidation of European custodial arrangements, a switch away from using multiple identifiers for different listings of the same fund and, just as importantly, the continued promotion of the potential benefits from ETF lending by issuers and fund advisors. iShares has been at the forefront of ETF issuers in supporting this, with a number of publications on the subject, and a team of specialists to advise investors on the subject.

In summary, in European ETF securities lending, we see a number of factors that are typical for a market progressing from an initial growth spurt to a more mature period of development. Market participants and infrastructure providers appear equally motivated to move from the current illiquidity and low levels of visibility to a deeper and more transparent secondary market. While the current opportunities for arbitrageurs may decline, this trend is something that should benefit the wider European investor base via reduced fees and trading costs.