With 1,304 funds and €215 billion assets under management, Exchange Traded Funds (ETFs) listed in Europe are a major element of the European fund management industry. However, some feel that European ETFs are hindered by a lack of liquidity as compared to their counterparts in the US ETF market, and that European ETFs could be even more robust if they followed the US model of employing greater levels of securities finance and collateral management. A white paper released on September 18, 2012, “ETFs, Securities Finance and Collateral,” looks at ETFs in Europe and the reasons for their relative lack of activity in the securities finance world. In their paper, Roy Zimmerhansl of FinTuition and Andrew Howieson of Howieson Consulting examine European ETFs relative underdevelopment of securities lending and collateral management relevant to European ETF shares. The authors also make a series of recommendations for co-ordinated changes at both individual firm and market levels required to promote development of an active securities lending market in European ETFs, driving improved liquidity in ETF trading and better risk management.
Some US ETFs are amongst the most actively traded listed securities in the world; there is a deep supply of ETFs available for loan; the fees payable by borrowers are in line with equity borrowing costs with a similar supply/demand ratio; and it’s all supported by a wider audience of ETF collateral takers. This is a model that works. European ETFs present a different picture, but the influencing factors are the same and the potential for substantial growth remains.
According to the authors, emulating the securities lending model employed by US ETFs, European ETFs could provide
- an opportunity for increased revenue for beneficial owners and agentlenders;
- increased use of European ETFs by market makers and hedge funds;
- expansion of activity in the space by prime brokers; and
- ultimately increased trading activity on-exchange and in the OTC markets should result in decreased bid-offer spreads for investors.
They note, however, that more active securities lending in European ETFs requires changes both at the individual firm level, and industry wide, and the paper explains why these changes are not only good business, but also good risk management.
Individual Firms
- Increase the use of ETFs as collateral
- Increase lending ETF shares themselves
- Increase borrowing demand for ETFs
Industry Wide
- Establish ETF Classification System
- Define Best Practice for Lending ETFs
- Define Best Practice for use of ETFs as Collateral
The lack of development in securities lending is a major factor in the relative illiquidity of European ETF markets. This review provides much needed discussion and evidence that application of current industry standard measurements, including liquidity and diversification measures, fails to recognize the characteristics of ETFs and inappropriately restricts the availability of ETFs to lend. In addition, demand (largely represented by hedge fund participation) is restricted through lack of European ETF availability for borrowing to cover shorts and inability to finance long positions for both hedge funds and their prime broker service providers. Consequently, the coordinated change the authors suggest may be just the shot in the arm European ETFs need to meet their full potential.