The Dark Side Of Stock Lending

Imagine you’re invested in an exchange-traded fund focused on government bonds. And you’re pretty happy about that, as the markets have been choppy lately. And you feel an even bigger sigh of relief when, on a beautiful mid-October morning, the markets turn stormy. Shares are sinking, corporate bond yields are spiking, and you’re a bit of a smug cat with that safe fixed-income ETF.

Plus, it’s cheap, you say to yourself, because I’m holding it for the long term, and it’s physically replicated, so I know what I’m getting. My index is diversified, therefore I’m spreading my risk. The tracking error is close to zero: This means the ETF issuer must be following the index to the letter.

Think again.

Without sounding too dramatic, if we really do enter Financial World War III, that’s when you’ll get closer than ever before to finding out what is under your ETF bonnet.

Here’s why. Remember securities lending? In its simplest form, an ETF issuer lends out stocks in a fund—which it has bought for a physically replicated ETF—to another institution. In the meantime the ETF issuer gets the cash, plus some collateral from the borrower to make the loan secure.

A Closer Look At Collateral

With ETFs, this collateral is usually made up of shares. I will take the example of the iShares Euro Government Bond 1-3 Year UCITS ETF. It currently has 33.8 percent of its assets out on loan, and this can go to a maximum of 41.8 percent.

The collateral basket received in return is clearly displayed on iShares’ website. Top collateral holdings are Italian bank UniCredit at 4 percent, followed by Italian bank Intesa Sanpaolo and Spanish bank Banco Santander at 3.7 percent and 2.5 percent respectively. In this case there is a 10 percent haircut, so the collateral is worth 110 percent of the stock on loan.

Let’s rewind a step. If the markets tank, you expect your government bond ETF to take off, because everyone will pile into less risky assets. Except that over 30 percent of your ETF is out on loan and you have a basket of shares in its place. And those share prices are collapsing. Suddenly that 10 percent collateral haircut doesn’t seem like such a safe margin.

So where have all your government bonds gone?

They’re in the hands of the banks, who are frantically deleveraging their balance sheets amidst new regulations like Basel III which require them to hold seven times more cash and risk-free assets then pre-crisis, and they are trying to find a useful way to lend out all of the “bad”, “toxic” stuff that nobody wants. An ETF wrapper can sometimes become quite a handy wasteland.

Now take a second look at your collateral basket. Scroll on for 45 pages and you get to small and niche stocks that most people wouldn’t touch with a bargepole: Have you heard of Israeli-based “BATM Advanced Communications Ltd”?

This is called “collateral upgrade swaps” by the bank, but is starting to be called something definitely seedier—“regulation arbitrage”—by the Bank of England. Have a read of a speech on Thursday 6 November by Bank of England executive director of prudential policy, David Rule, on the subject here.

In particular, he says: “For example, the authorities need to understand the composition of the collateral being used across key financial markets in order to identify concentrations. The financial crisis showed the risks associated with a market-wide margin call when widely-used collateral is subject to an unexpected common price shock.”

Do you want 4 percent in UniCredit when Spanish and Italian bank stocks start to tumble?

Securities Lending Prevalent

Let’s be clear – securities lending does not just happen in ETFs, it also occurs with investment trusts, index funds, hedge funds and other actively managed mutual funds. The second disclaimer is it’s not just iShares. Amundi, ComStage, db X-trackers, Deka ETFs, Lyxor, UBS and SPDR all carry out securities lending on some of their ETFs. Full information on what stock they lend out and how much they make in return is available in Morningstar’s latest ETF report, “A Guided Tour of the ETF Marketplace”, published in November.

Peter Sleep, portfolio manager at asset manager 7IM, said the increased monitoring of “securities financing”, or stock lending to the layman, is intended to stabilise financial markets and is ultimately a good thing. He also questioned why end investors should only receive 62.5 percent of stock lending revenue from iShares, for example, and accept 100 percent of the risk.

That is a fair point. However, iShares would insist this is not the case. Page 42 of the above product's prospectus says: "To mitigate these risks, the Company benefits from a borrower default indemnity provided by BlackRock, Inc. The indemnity allows for full replacement of the securities lent if the collateral received does not cover the value of the securities loaned in the event of a borrower default."

If the demand from banks to borrow clean assets from ETFs weakens, ETF providers will generate less return from lending activity and will therefore be less able to offset management fees: that has to mean that costs for the end investor will go up. You may call me a doomsayer in the short term, but you have to agree I am making a logical conclusion in the longer term.

There are a couple of important lessons there – an ETF is just a wrapper. How the ETF generates the returns of its index is completely different from provider to provider.

Second, you can choose a physical ETF to avoid derivatives, or you can pick a synthetic ETF to sidestep securities lending – but all you might end up with is the same basket of collateral.