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September 5, 2016

Monday Morning Memo: Securities lending remains a hot topic in the European ETF industry 

by Detlef Glow.

After iSharesthe exchange-traded fund (ETF) arm of the world’s largest asset manager, BlackRockannounced last year that it has scrapped its self commitment on the percentage of securities held by the firm that can be lent to third parties, Vanguard announced recently that it also will increase its involvement in securities lending. This step is rather surprising, since securities lending by ETFs is one of the main points raised by critics, and this step by Vanguard may once again fuel the discussion about possible systematic risks associated with ETFs. The increasing securities-lending activity may be the answer for fund promoters to the falling income from management fees, since these fees could further decrease and put pressure on ETF promoters’ profitability. But not all ETF promoters use securities lending in their funds; HSBC Asset Management for example has introduced a ban on securities lending for its ETFs in 2013, while UBS ETF continues its limit of the maximum percentage of securities that can be lent.

Since securities lending is a normal technique in modern portfolio management, it might be surprising that there is so much discussion around this topic. There are positive effects for the overall markets that come from securities lending, since it makes the markets more efficient by creating additional liquidity through the trades that need to be done to sell and buy back the borrowed securities. Another positive impact comes from the fact that short-sellers try to sell stocks that look overvalued for any reason. These transactions might help prevent single stocks from reaching exorbitant valuations for no reason.

In addition to these positive impacts, there are also negative impacts from securities lending. Firstly, one needs to take into consideration that the possible loss caused by short-sellers can be larger than the income from the lending fees for the respective portfolio. This means investors may lose money, since they may try to earn a small fee for lending out securities to a third party that turns around and sells them immediately on the market. By the way, the income from these transactions is normally shared between the fund promoter and the investors in the fund. Sometimes the fund promoter states this in a nice phrase such as: “the fund retains all income from securities lending minus the respective fees.” This may sound good, but how much is the fee for maintaining the securities-lending program, and who retains this fee? Is it the fund promoter or a related company, or is the fee paid to a third party? If the lending program is maintained through the fund promoter or a related company, the fund promoter has a high interest in lending out as many securities as possible, since that increases its overall revenue/profitability. If the fee goes to a third party, the fund promoter may think twice about the risk coming from the transactions, since there is no impact on the fund promoter from a revenue/profitability point of view.

One may argue that the investor bears no risk from securities-lending activities, since normally all transactions are secured by collateral. That is right, and in most cases these transactions are even over-collateralized. But, since the current regulations on which securities can be used as collateral are rather weak, some market participants may use the collateral to offload toxic or illiquid paper from their balance sheet. If a bank wants to reduce risk on its balance sheet, it may borrow some government bonds from a fund and return unrated or other risky assets as collateral to the lender. This may not look like a serious issue for fund shareholders at first sight, since they won’t own this paper unless the borrower defaults. But if there is a default, it would be questionable whether all the securities in the collateral are liquid and at what price they can be sold to pay the dues. In this case even an over-collateralization might not protect the investor from a loss in the net asset value of the fund.

From my point of view, the idea of securities lending is not bad at all. But to follow this strategy with securities held in a mutual fund, which is owned by long-term retail investors who can’t evaluate the risk of this kind of activity, is a bad idea, especially when the revenue from securities lending is shared between the fund promoter and the investor. In this regard regulators should force fund promoters to disclose in the key investor information document (KIID) whether they are doing securities lending and how the revenues are shared. In addition, the regulators should set clear and strict guidelines on the quality of the securities used as collateral, since this would decrease the level of risk for the investor.

It would be helpful for the investor if all funds (securities lending is not only used by ETFs; active funds can be heavy users of this technique) would disclose on their website the collateral they accept for the securities they lend out. This would help fund selectors and investors make educated decisions on the risk they might have from securities lending within the fund and would lead to better decisions in the fund selection process. Even though some promoters may find this level of transparency hard to achieve, investors should claim a need for this information; they own the assets of the fund and the promoter is the fiduciary who should act in the best interest of the investors.

In this regard regulators should think about a ban on all securities-lending activities from retail mutual funds if fund promoters are not willing to disclose all the information needed by investors to make a proper evaluation of the mutual funds.

After the financial crisis of 2008 investors and regulators have become very cautious about the use of derivatives. I could imagine that this may also happen to securities lending and the involved collateral employed by mutual funds. I hope it doesn’t take a new crisis before the risks of the extensive use of this portfolio management technique are realized and regulated by the authorities.

This article is the follow-up to my Monday Morning Memo Securities lending–the dark side of mutual funds, which was published on July 20, 2015.

The views expressed are the views of the author, not necessarily those of Refinitiv.


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