Investing Basics: Security Lending and ETFs

Security lending is one of the dark arts of investment management – boosting returns and increasing risks for investors. Find out what your ETF provider is up to…by Dominique Riedl

Did you know that you can loan out shares, bonds and other securities you own to third parties in exchange for a fee? This practice is known as security lending and it’s a $1.72 trillion global market participated in by financial institutions ranging from pension funds to insurance companies to fund and ETF providers.

As an ETF shareholder, it’s likely that securities owned by your ETF are lent to other financial players such as hedge funds, broker-dealers, market-makers, the trading desks of investment banks, or even highly sophisticated private traders.

Although securities lending caused some disquiet in the aftermath of the Financial Crisis, it’s widely seen as a good thing that enhances market liquidity, efficiency and price discovery.

Your ETF manager likes it because it’s a straightforward way to earn extra revenue that can reduce costs and ensure the fund tracks its benchmark more snugly.

Borrowers benefit as they can use loaned securities to short-sell, hedge an investment (such as a derivative or convertible bond), boost their voting rights at a key time or exploit an arbitrage opportunity.

How does securities lending work?

 Your ETF may agree to lend a particular security to a third party. In return, the borrower pays a fee plus collateral to cover the value of the security while it’s on loan.

If the borrower refused to return the security (a default), then the lender can sell the collateral to cover the loss.

In the meantime, the lender will often reinvest the collateral to generate extra income during the loan period.

Often the value of the collateral is higher than the security which helps protect the lender from adverse changes in the market price.

Most ETF providers check the collateral’s value daily and may request more if it falls too far.

Loans are usually made on an ‘open’ basis. That means the loan isn’t for a fixed duration but can be called in at any time. (Very helpful if conditions deteriorate and the lender wants to reduce their exposure to the borrower quickly). Legal ownership of the security actually transfers to the borrower, so they can return its value in cash or other securities if they wish – enabling the lender to buy it back in the market as necessary.

What are the risks?

 The chief risk associated with security lending is that a borrower may default.
 

In that scenario, an ETF provider recovers their position by selling their collateral on the market and repurchasing the lost securities.

The danger is that poor quality collateral may be highly illiquid or difficult to value. You wouldn’t want to be selling Collateralized Debt Obligations (CDOs) in 2008.

For that reason, the EU’s UCITS rules prescribe a set of risk-control standards on UCITS ETF collateral, and most of the major players impose stricter criteria still.

For example, collateral may consist of G-10 government debt, high quality corporate debt (A1 or above), and equities from approved OECD markets.

Rules also govern the level of collateral diversification (no more than 30% from a single issuer) and security lending counterparties must have a minimum credit rating of A2 or above.

And the rules have been tested. BlackRock – the owner of the iShares ETF brand – has experienced three security-lending defaults since 1981 but has compensated all three from collateral.

More obscure is the investment risk taken when lenders reinvest collateral to earn a return. Normally collateral is invested conservatively in money market securities. However, some lenders were caught out by the demise of Lehman Brothers’ money market funds in 2008.

Even in rare and extreme events like this, major ETF providers can protect their investors by indemnifying them against potential security-lending losses using their own balance sheets, or those of independent third-parties.

What are the benefits?

 As most ETFs hold thousands of securities there is plenty of opportunity to earn extra revenue through security-lending fees, reinvestment of collateral and yet wilier practices.

Fees are governed by the laws of supply and demand. Different sectors, markets and countries will fall in and out of favour – although you can generally expect illiquid small caps to command a higher premium than low-yielding government bonds.

Lenders also send out securities to take advantage of tax arbitrage. In this case, it’s the borrower who will receive the dividend or bond interest payment – saving the lender a portion of their tax bill. However, a deal will be struck whereby the borrower hands the income back to the lender but at a more favourable tax rate due to the different treatment of fees.

Securities lending further enables major institutions to muster cheap short-term liquidity – generating cash (from collateral) in exchange for the loan.
But how do these opportunities benefit you and me?

Serious ETF players are transparent about how much of their security lending income boosts their investors returns versus corporate profits.

For example, iShares states that 70 – 80% of security lending income is used to reduce fund costs and thereby improve performance.

This usually means a trim for the ETF’s OCF which can occasionally be wiped out entirely.

What should you look out for?

 Security lending is largely positive for ETF investors but there is a trade-off between risk and return, as always.
Check out your ETF provider’s security lending policy on their website and look out for:

• A cautious lending-policy based on selecting well-capitalised borrowers.
• Borrower concentration limits.
• The maximum percentage of ETF assets that may be lent.
• The quality of collateral accepted.
• The amount of over-collateralisation i.e. the value of collateral held over and above the value of securities lent.
• Daily re-evaluation of collateral value (mark-to-market) and top-up trigger points.
• Borrower default indemnification coverage. Who provides it?
• The percentage of security lending income returned to the ETF.

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