Counterparty Risk In Securities Lending For ETFs

Index Universe reports about counterparty risk in securities lending for ETFs.

(emphasis mine) [my comment]

More On Counterparty Risk (Securities Lending)
Written by Paul Amery
Monday, 20 October 2008 11:22

Securities lending is very big business for the largest investment funds and fund managers. For example, CalPers, the California state pension fund, earned nearly $1.2 billion from lending assets over the eight years ending in June 2008 (on a pool of securities lent that was most recently valued at $38 billion) - in other words it enhanced returns by more than 30 basis points per annum over the period. For the biggest fund managers in the indexing and ETF business - BGI, Vanguard, State Street, Northern Trust - securities lending revenues are a significant contributor to overall profits.

However
a number of big problems have arisen for the securities lending business in recent months: first, concerns about possible default by stock borrowers have increased; second, some significant losses have occurred in cash reinvestment programmes (where managers reinvest the cash collateral received in exchange for the stock loaned); third, regulatory restrictions on short-selling have caused a dramatic slowdown or even a stop to lending in certain areas of the market.

IndexUniverse.eu surveyed a number of
leading European ETF providers and posed them questions about their securities lending activities. The managers that have participated in the survey are iShares, Lyxor, db x-trackers, easyETF, XACT, ETFLab and ETF Securities. BBVA, the Spanish ETF provider, explained that it had only in specie ETFs, and did not lend its ETFs' securities.

All answers refer to European-domiciled ETFs only.

1) Of the ETFs you manage, how many are involved in securities lending?

iShares -
From our Dublin product range 30 iShares ETFs are currently involved in securities lending. In addition, all 81 iShares ETFs from our Munich product range are involved in securities lending. [GLD is an iShares ETF]
Lyxor - We do not lend out the underlying collateral in the funds (IU note - Lyxor's ETFs are all swap-based)
db x-trackers - There is no lending of the assets of any of the db x-trackers ETFs (IU note - db x-trackers' ETFs are all swap-based). However, with swap-based ETFs, it is possible to generate lending revenues which can be passed on in the performance of the ETF to offset the impact of management fees. The relevant trading desk at DB will invest in the underlying index components to hedge its exposure under the swap. These stocks form part of the DB's lending pool and any revenues generated can be passed on to the ETF as an enhancement. The difference between this approach and traditional stock lending at the fund level is that there is no borrower default risk for the ETF. These risks are faced by DB only and there can be no negative impact on the performance of the swap.
easyETF -
All our fully-replicated ETFs (21/58 ETFs) use securities lending. Those of our synthetically-managed (swap-based) ETFs which hold equities as collateral also have lending transactions.
XACT - 2 out of 11 ETFs use securities lending
ETFLab -
All our 10 ETFs use securities lending to improve performance
ETF Securities - currently our swap-based ETFs do not engage in securities lending

IU comment - Note that, although securities lending is primarily the domain of in specie ETFs (which fully or partially replicate the underlying index), both db x-trackers and EasyETF undertake lending from within the collateral basket used to back their swap-based ETFs. Lyxor and ETF Securities, on the other hand, do not do so for their swap-based ETFs.

A very varied set of practices.

IU has been unable to quantify the effect of enhancements to swap-based ETFs from the lending of stocks in the collateral basket. The securities lending revenues earned by in specie ETFs are typically quantified in the annual report and accounts.

2) Who is the approved agent for stock lending on behalf of the ETFs?

iShares - BGI Ltd. is the appointed lending agent for our Dublin iShares funds, while for our Munich iShares funds it is handled via Clearstream and HypoVereinsbank's le nding desk.
Lyxor - not applicable.
db x-trackers - not applicable.
easyETF - BNP Paribas Security Services
XACT - Handelsbanken
ETFLab - Clearstream Banking, DekaBank Deutsche Girozentrale, Frankfurt am Main
ETF Securities - not applicable


3) What is the level of (over)collateralisation required when stock is lent (i.e., what is the margin cushion)?

iShares - We conduct rigorous analyses of the liquidity and volatility characteristics of the collateral accepted to ensure that, in the unlikely event that the collateral needs to be liquidated, the sale proceeds would be sufficient to repurchase the loan securities. We never accept "daylight exposure" in our lending programme and ensure that we hold collateral before releasing loan stock. Collateral types and limits are scientifically set and regularly reviewed to protect our lending funds.
Collateral margins for our Dublin iShares range vary from 102.5% to 110%, depending on the assets provided as collateral. For our Munich iShares ETFs, margins are at least 105% for fixed-income ETFs and at least 110% for equity ETFs.
Lyxor - not applicable
db x-trackers - not applicable
easyETF -
Lending is fully collateralised
XACT -
105%
ETFLab -
At least 105%
ETF Securities - not applicable

IU comment - Overcollateralisation protects the lending fund in the case of a borrower default, by ensuring there is a margin cushion to cover any costs involved in selling the collateral and repurchasing the shares which had been lent out. The margins used range from 102.5% to 110% (EasyETF provided no detail here). iShares also specifies that it doesn't accept "daylight exposure" - meaning that borrowers have to pay cash (or securities) upfront to secure a loan.

4) Are there any borrower default indemnities given to the ETF to protect the fund against losses over and above the margin cushion?

iShares -
Borrower default indemnifications are not part of our standard product offering. [any loses from ishares lending program will fall on holders of ETF shares]
Lyxor - not applicable
db x-trackers - not applicable
easyETF - not applicable
XACT -
no
ETFLab -
no
ETF Securities - not applicable

IU comment - borrower default indemnities are sometimes given by lending agents to ensure that the fund suffers no loss if the cost of liquidating collateral and replacing the lent shares exceeds the margin cushions set out in the answers to question 3. However none of the ETF providers surveyed offer these to their funds. This means that in case of a borrower default funds would be exposed to losses over and above the margin cushion.

5) How often are positions marked to market and collateral payments made?

iShares -
Daily
Lyxor - not applicable
db x-trackers - not applicable
easyETF -
Daily
XACT -
Daily
ETFLab -
Daily
ETF Securities - not applicable

6) What do you accept as approved collateral on behalf of the ETF for securities lent? What is collateral investment and reinvestment policy?

iShares -
The range of collateral instruments that we can accept for our Dublin iShares includes high quality corporate and government debt ['AAA' debt and US treasuries]. The same applies to Munich iShares, with these funds also accepting stocks previously approved by the control department.
Lyxor - not applicable
db x-trackers - not applicable
easyETF -
money market instruments
XACT -
Only cash. The agent does not require re-investment of the cash collateral
ETFLab - Equities, Bonds or cash
ETF Securities - not applicable

IU comment - Only XACT insists on cash collateral, with iShares, easyETF and ETFLab taking securities of some kind. While cash seems a safer bet if you're a lender, the biggest securities lending losses of recent years have come from badly-(re)invested cash collateral. This doesn't seem of relevance for any of the managers here - XACT specifies that cash collateral is not reinvested - but it's worth being aware of as a potential risk. As a side-note, State Street, Northern Trust and BONY have all made announcements this year regarding losses from reinvested cash collateral, although it remains unclear whether such losses have been passed on to their clients, the lending funds who are beneficial owners of the securities

7) When securities are lent, how is the resulting revenue split between you, the manager, and the ETF?

iShares -
The fund receives 50% of the gross lending revenue, the remainder goes to BGI. All operational and transactional charges are covered from this. We frequently benchmark our funds' Securities Lending performance and we regularly outperform the market. Our focus is on total returns, not relative splits, since this is what matters for the fund's performance.
Lyxor - not applicable
db x-trackers - not applicable
easyETF -
the revenue is always split between the manager and the fund at a 50/50 rate. Lending optimisation can deliver an extra 10 bps per annum to the fund, offsetting management fees
XACT -
Everything to the ETF
ETFLab -
Everything to the ETF
ETF Securities - not applicable

IU comment - this is a big contrast, with iShares and EasyETF taking a 50% cut of gross revenues, XACT and ETFLab passing all revenues to the fund. This split continues to provoke debate amongst ETF market observers. Why shouldn't the fund receive all the revenue? On the other hand, lending agents argue that securities lending revenue is "value added", so they should be remunerated for it. To complicate matters further, investors must take into account more than revenue splits when evaluating a manager's securities lending programme - risk management policy is key.

In summary, the survey reveals some quite significant differences in the way ETF providers use securities lending, from the number of funds involved, to margin and collateral policies and the split of revenues.

As far as counterparty risks are concerned, while margin cushions of 2.5-10% provide significant protection against borrower default, there are still some risks remaining - recent volatility has given us plenty of examples of daily market moves of more than that.

Cash collateral reinvestment risk is a hot topic in the securities lending market, because of recent losses, but it doesn't seem to be of direct relevance to the ETFs involved in this survey.

And, last of all, the survey has shown up some significant differences in the way securities lending revenues are split between managers and the ETFs. Surely there's some scope for increased competition here?

My reaction: All non-swap ETF providers engage in Securities Lending, introducing a level of risk most investors don't have a clue about.

1) A number of big problems have arisen for the securities lending business (like those used by ETF providers) in recent months:

A) concerns about possible default by stock borrowers have increased
B) some significant losses have occurred in cash reinvestment programmes (where managers reinvest the cash collateral received in exchange for the stock loaned)
C) regulatory restrictions on short-selling have caused a dramatic slowdown or even a stop to lending in certain areas of the market.

2) Collateral margins ETF lending program range from a measly 102.5% to 110%.

3) No ETF provider includes borrower default indemnifications as part of their standard product offering, which means lending program losses are absorbed by ETF investors.

4) Managers at iShares and EasyETF make extra profit through their securities lending program by gambling with the assets of ETF investors.


Conclusion: This is the reason I don't like ETFs: the more you know about them, the worse they are.

This entry was posted in Background_Info, Financial_Wizardry, Wall_Street_Meltdown. Bookmark the permalink.

3 Responses to Counterparty Risk In Securities Lending For ETFs

  1. dashxdr says:

    Several days ago I finally sold the last of the GLD under my control, and switched to GDX for now.

  2. Anonymous says:

    Thanks for explaining on risks of ETF's.

    What do you think about Jim Rogers indices? (RICI- Jim Rogers commodities index, and there are also subindices, for only investing in a sector like metals or food)

    And always great work!!

    Greetings from Belgium...

  3. Jimmy says:

    dashxdr, Eric,

    What kinds of counterparty risks are there with stocks, like GDX, SLW? Does the brokerage (like scottrade) lend them out without knowledge and approval of the true owner?

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