White paper dismisses myths on European ETFs
“ETF Liquidity, Securities Finance and Collateral Management; Maximising the role of European Exchange Traded Funds”, published by Roy Zimmerhansl of FinTuition, a training and consultancy firm, and Andrew Howieson of Howieson Consulting, argues lending ETF shares is no different to lending equity instruments.
Despite this, Sungard Astec Analytics reveals US ETF shares on loan equivalent stands at 3.67% of US listed ETF AuM while European ETF shares on loan equivalent is 0.34% of European listed ETF AuM (at May 2012).
“Our review finds that application of current industry standard measurements including liquidity and diversification measures fails to recognise the characteristics of ETFs and inappropriately restricts the availability of ETFs to lend. Equally, demand 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 brokers,” reads the report.
Prime brokers’ find it difficult to source European listed ETFs to support shorting and finance long positions thereby pushing costs up exponentially in Europe. Data shows that shorting an ETF in the US costs between 10 and 25 bps while shorting a European listed ETF costs between 100 and 300 bps.
Part of this supply issue lies with agent lenders’ discomfort with ETFs, as well as industry perceptions that the ETF market is illiquid, commented Andrew Howieson. This, he said, was misguided.
Roy Zimmerhansl agreed “ETF shares have many of the benefits associated with listed equity instruments, if not more. Furthermore, the lack of lending of ETF shares impacts the liquidity of the European ETF market. The lack of sec lending in the European ETF space is a key reason for the market’s relative illiquidity compared to the US,” he said.
One way to resolve the shortage of lendable ETFs is for financial institutions to create their own and lend out to clients to short, the paper said. However, this is not without its challenges. Regulators, for example, are already taking aim at ETFs in Europe, and could prove to be a stumbling block.
Furthermore, create to lend could be a loss-leader if the ETF is returned to the lender earlier than anticipated and before the lender has been able to earn back the charges. This could result in lenders not recouping their creation fees as well as being stuck with the asset unable to find a borrower.
While the use of the ETF as collateral is a possibility, it could be a struggle to find a financial institution willing to accept the ETF as collateral. “This results in a premature redemption, possibly incurring additional fees,” the paper added.