The Big Difference Between Pawn Shops And Securities Lending

How are pawn shops and physical ETFs alike? That question would have stumped me until a recent paper crossed my desk (the Bank for International Settlements Working Paper 479: “Understanding the role of debt in the financial system”).

The similarity I mentioned comes down to securities lending. When either the pawn shop or the ETF lend out stock, they need some kind of collateral in return, in case their counterparty goes bust. As neither of them determine an accurate market price for what they are lending out, they demand extra collateral to cover the potential loss – called a “haircut”.

Average Joe loans out his gold ring

Let me explain further. In the pawn shop, the average Joe might receive £75 in exchange for his gold ring. The pawn shop gives Joe less money than it’s worth in the market, and Joe has the option to buy his treasured ring back later – at a higher price. Now imagine the fixed income ETF manager is the average Joe. He wants to maximise investor returns, so he loans out some of his government bonds to another institution, and gets back some collateral – usually in the form of a big bundle of equities. He gets a lot of equities, with the aim that their collective value would cover what could be potentially lost.

Which is the safer bet?

I would argue there is one big difference between pawn shops and ETFs that could make security lending more risky for the ETF owner. A pawn shop deals on its own account: if money is lost, the shop takes the hit.  With ETFs, a lending agent acts on behalf of the ETF owner in return for a share of the profit. If there is a loss, the ETF owner takes the hit. The agent is paid to maximise revenues for the ETF issuer and owner, but is not necessarily hurt if something goes wrong.

Safe bonds in return for volatile equities

Particularly in Europe, some securities lending has become a part of the “collateral transformation” industry. Physical ETFs lend their treasuries, gilts and bunds and accept equity as collateral. Collateral transformation is attractive to financial institutions. It gets volatile equities off their balance sheets and they receive treasuries, gilts and bunds that can be easily converted to cash.

There are checks that agents go through to help prevent losses. They might, for example, only lend to certain counterparties, but there is not really a check on the quality of the equity collateral they receive. The European regulators say that, in broad terms, the equity has to be quoted on a recognised exchange.

There are other checks on liquidity, but a lot of reliance is placed on the haircut. There is no detailed attempt to price each stock in terms of quality as collateral. Whether the equity collateral is Apple, a European bank, or an emerging market American Depositary Receipt listed in New York, they all receive the same haircut. All these equities can be found in physical ETF collateral baskets today.

One rule does not fit all

Having a uniform haircut rate, no matter what the security, means there is no price discovery. Some equities may be more valuable as collateral than other equities, but they all receive the same haircut. A true price discovery mechanism might impose different haircuts upon different equities.

I think this is important if there is a significant bankruptcy. Let’s say a big bank goes bust and the treasuries, gilts or bunds in your physical ETF are lost. Your agent will have to sell the equity collateral into a very distressed market in order to the buy the bonds back. It might be easy to sell some stock at a robust price, but I am not sure that it will be as easy to sell them all of them at a robust price. It is quite possible that the 10 percent haircut – or whatever the haircut for your ETF is – will be insufficient.

Trust that your ETF issuer has got it covered?

It is at this point that ETF owners might rely upon any indemnity that may be provided by their agent.  An indemnity may offer you some form of protection against loss in the event of a bankruptcy. This is not a good place to be though, as it then comes down to the precise wording of the indemnity and the financial strength of the agent.  What would your client or trustees say if their treasuries, gilts or bunds went missing while on loan?

The pawn shop model is robust and has stood the test of time. The first pawn shops were recorded by the Tang dynasty around 650 AD. But they do get it wrong. Albermarle & Bond in the UK got into financial difficulties when the price of gold unexpectedly fell in 2013.

If securities lending in ETFs is to continue, it is perhaps necessary to think more carefully about security lending collateral – what is being borrowed, and what are you getting in return.