In a report issued April 12, 2011, the Financial Stability Board (FSB) highlighted a number of practices engaged in by exchange-traded funds that may be sources of risk to financial stability. Calling for greater disclosure and transparency, securities lending was among the practices red-flagged by the FSB.
The FSB warns that in the low margin environment of ETFs, pressures to boost returns may provide undue incentives to aggressively, and potentially unwisely, lend the underlying securities of the ETF.
[T]hin margins on plain-vanilla physical ETFs create incentives for providers to engage in extensive securities lending in order to boost returns. Some ETF providers are said to generate more fee income from securities lending than from their traditional management fees.
The report voices concerns that over-reliance on securities lending, particularly among synthetic ETFs, amplifies counterparty, collateral, and liquidity risks.
Since securities lending is a bilateral collateralised operation, it may create similar counterparty and collateral risks to synthetic ETFs. In addition, it could make the liquidity position of the ETF fragile, by challenging the ability of ETF providers to meet unexpected liquidity demands from investors, particularly if outflows from ETFs become significant under severe stress. A prevalence of securities lending could create a risk of a market squeeze in the underlying securities if ETF providers recalled on-loan securities on a large scale in order to meet redemptions.
While some jurisdictions like the United States have limits on the amount of an ETF’s portfolio that may may be on loan at any given time, collateral levels, and recalling of lent shares which may help to address certain of these risks, the FSB is also concerned with the complexity and opacity created not by ETFs lending underlying securities, but the use of ETFs as collateral.
In addition, the use of ETFs as collateral in a long chain of secured lending and rehypothecation may create operational risks and contribute to the build up of leverage.
The report calls on regulators, ETF providers, and investors to review the risk managements strategies of ETFs, “especially in areas such as counterparty risk and collateral management, as well as assessing their exposure to market and funding liquidity risks.
The FSB also calls for greater transparency regarding ETF products and associated risks, particularly for the more complex varieties.
ETF providers should consider enhancing the level of transparency they offer to investors on the entire range of ETF products, especially the more complex ones. In particular, they should make publicly available detailed frequent information about product composition and risk characteristics, including on collateral baskets and arrangements for synthetic ETFs and securities lending, to enable investors to exercise their due diligence and promote a better understanding of the ETF market at large.
For additional perspectives and some counterpint on this issue, see
FundWeb:
Regulators Voice Fears Over Danger to Retail Investors
iShares Blog:
ETF Mythbusting: Securities Lending Within ETFs