ETF shares are increasing in investment portfolios but still idle in Europe
Created just 25 years ago, ETFs broke through the USD5 trillion in assets under management (AUM) mark in February this year, and are expected to reach USD7.6 trillion by the end of 2020. This may remain only a minor slice of the world’s invested assets, but the growth trend is clear.
In the United States, by far the largest and most mature market, they now make up 13 percent of the funds industry total AUM. Along with new inflows and asset appreciation, this growth in part comes from a shift out of traditional mutual funds, which saw net outflows of minus USD277 billion, compared to an increase of USD167 billion into ETFs tracking the same types of assets.
Outside North America, ETF markets are more nascent, but that is fast changing. In Europe, AUM has doubled in the past five years, and the forecast is for further growth in the coming years.
Yet while ETFs are becoming an ever more crucial constituent of (especially institutional) investors’ portfolios, for the most part in Europe they remain idle in their investment portfolios, and are not being used within their securities lending programmes to generate additional revenue. At a time of growing collateral demands—especially to meet regulatory obligations, as with the European Market Infrastructure Regulation (EMIR)—ETFs could also serve as valuable collateral instruments for European financial institutions.
Three questions before optimising ETFs value
To date, three main issues have limited the use of ETFs in securities lending and as collateral in Europe. Overcoming these will be an important step in helping the industry further develop and grow.
What are ETFs’ key features?
It is an investment fund that tracks an index, a commodity, bonds, or a basket of assets like an index fund. They offer investors collective exposure to a wide variety of assets, providing almost limitless investment possibilities, and a broad exposure to a diversified pool of asset classes, typically with reduced exposure to single security volatility. They tend to be relatively low cost, although ETFs that track less liquid indices will have higher expense ratios. They are also priced intraday, providing greater transaction flexibility than mutual funds.
Within the broad universe, ETFs can vary depending on their constitution and management. The key distinctions are
- Physical replication: the portfolio manager buys the same underlying securities that compose the index being tracked
- Synthetic replication: it aims to replicate the performance of an index using swaps, rather than physical securities
- Equity ETFs: the underlying index could be anything from the S&P 500 to an emerging market equity index
- Bond ETFs: span everything from European government debt to corporate bonds
- Other assets: new forms are emerging all the time, and may include commodities, currencies or alternative investment products.
- Passive management: it replicates the index performance exactly
- Active management: the portfolio manager tries to outperform the index, for example using derivatives to create inverse or leveraged ETFs
Some ETFs have garnered a poor reputation. As a recent Financial Times article observed, an ETF’s price fluctuates according to the value of its underlying assets. The integrity of that price depends on the models and contracts that link everything together.
Another complaint has been a lack of transparency. Since the January rollout of the second Markets in Financial Instruments Directive (MiFID II) though, European investors now have access to more information about the functioning, composition, size and liquidity of funds, as seen with the mandatory reporting of over-the-counter (OTC) transactions. In addition, most European ETFs are structured as UCITS, which provide end-investors with the guarantee of a depositary bank, for example for asset restitution.
Risk concerns have been a further factor. Yet, while synthetic ETFs may appear riskier than physical replication vehicles, since March 2017, EMIR has required mandatory collateralisation of swaps, which is changing the risk profile.
Are ETFs liquid?
Unlike traditional funds, investors have several options when ‘selling’ their ETF shares: the primary market, the secondary market and via OTC transactions.
In the primary market, liquidity relies on ‘authorised participants’. These market makers are charged with the creation and redemption of ETF units, which determine the supply of ETF shares and help keep the funds priced at fair value. Primary liquidity relates to how efficient it is to create/redeem shares, and is therefore a function of how easy it is to access and trade in the underlying instruments that back the ETF.
Approximately 90 percent of ETF units are then exchanged on the secondary market, where most non-institutional investors transact. Secondary market liquidity is determined by the volume and value of the supply of existing ETF shares being traded.
Given an ETF’s liquidity is primarily dependent on its authorised participants in both markets, there is a question of what would happen if an authorised participant steps back from this role. The biggest ETFs (great than EUR750 million in AUM) have an average of 35 authorised participants, with roughly nine of those active in the primary market. Although there is no contractual obligation for them to step in to take over the business, historically they have done so because it presents a business opportunity.
Article 23 of the European Securities and Markets Authority’s Guidelines on ETFs and Other UCITS Issues notes that investors should always be allowed to sell their units or shares directly back to the UCITS ETF if the stock market value varies significantly from its net asset value. “For example, this may apply in cases of market disruption such as the absence of a market maker,” notes the guide.
Fostering liquidity through securities lending: Securities lending—the ability to lend and borrow securities, for example to harness increased yield or allow market makers to cover their short positions—is today a fundamental component in the efficient functioning of financial markets. Securities lending activity improves market liquidity, market makers’ ability to perform their role and the market’s price fixing mechanism.
The ETF market is no exception. As it grows and develops, especially the volumes exchanged on the secondary markets, a vibrant ETF securities lending environment will enable authorized participants to operate more efficiently, and reduce the time and cost involved in creating and redeeming their shares. As we have seen elsewhere, this will create a virtuous circle by enhancing liquidity and market activity, thereby attracting new participants and further deepening and expanding the liquidity pools. When lending out their ETF units, long holders could benefit from additional revenues which can offset some, or even all, of the ETF management fee.
How to classify ETFs?
Today, neither the regulatory authorities in Europe nor the US consider ETFs as high quality liquidity assets (HQLAs), even if the underlying securities are government bonds (which are considered to be HQLA Level 1 assets under Basel III rules). This is paradoxical. In fact, the US and European authorities’ analysis was restricted to equity ETFs, and did not even consider fixed income vehicles.
The environment has also changed and continues to evolve. ETF volumes and liquidity are rising. In addition, UCITS, EMIR and MiFID II have increased investor protections and have gone a long way in addressing regulators’ previous counterparty credit risk concerns.
If the regulatory classifications were to be fine-tuned to reassess individual ETFs’ values in light of their true risk profile, market participants would be able to use the instruments more broadly.
At a time of growing margin demands, this would help expand the pool of available collateral, and reduce firms’ collateral and capital costs. With the European Central Bank planning to roll out a Eurosystem Collateral Management System by November 2022 to harmonise collateral operations across Europe, this is an opportune time to reassess the role of ETFs as collateral instruments in Europe.
ETF investors’ next steps for an optimised asset management
Significant interest already exists among European market participants in using ETFs as collateral. BNP Paribas Securities Services, like several other banks or other participants like investment companies, has accepted some as collateral for some time.
Classifying an ETF’s profile, to determine its eligibility, is a major challenge at present though.
Today, assessing the suitability involves considerable manual effort by firms’ risk departments to analyse exactly what is inside each ETF on a one-by-one basis. For many, the workload involved outweighs the benefit gained.
The solution, in addition to a regulatory reclassification, lies in more automated market data.
IHS Markit has made a first positive contribution by producing ETF collateral lists, which use its own filtering criteria to publish an inventory of eligible equity and fixed income ETFs. But only just over 100 names make the lists, out of a universe of some 6,000 ETFs.
There is still some way to go then until ETFs become widely accepted and used as collateral and in securities lending programmes. But with progressive change already evident, it is only a matter of time before they can realise their full potential.
Article initially published in Securities Lending Time
To read more about Collateral management:
Welcome to the tri-party
Initial margin for non-cleared derivatives: what is it?
Global ETF research 2017, EY : here
Réflexions sur les Risques des ETF, by Edouard Petit, 13 September 2017, €pargnant 3.0, here
The $5tn ETF market balances precariously on outdated rules, by Henry Hu, Financial Times, 23 April 2018, here
The Role and Activities of Authorized Participants of Exchange-Traded Funds, Investment Company Institute, March 2015, here
The Role and Activities of Authorized Participants of Exchange-Traded Funds, Investment Company Institute, March 2015
Guidelines for competent authorities and UCITS management companies: Guidelines on ETFs and other UCITS issues, ESMA, August 2014, here
Report on appropriate uniform definitions of extremely high quality liquid assets (extremely HQLA) and high quality liquid assets (HQLA) and on operational requirements for liquid assets under Article 509(3) and (5) CRR, European Banking Authority, December 2013,
Liquidity Coverage Ratio: Liquidity Risk Measurement Standards, Office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal Reserve System and the Federal Deposit Insurance Corporation, September 2014, here