ETF securities lending comes under scrutiny for collateral risk

Wealth managers using exchange traded funds (ETFs) should be aware of securities lending and the level of counterparty risk involved, with some funds lending out as much as 90% of their securities while holding Italian and Japanese equities as collateral.

According to iShares , its FTSE 250 ETF has lent out 92% of its securities, on average, over the last year. This average figure is very close to the maximum it has had out on loan, at 95%.

Returns from this practice, which went back into the fund amounted to a net figure of 14.7 basis points.

Ben Seager-Scott, senior research analyst at Bestinvest, said: ‘It is commendable that iShares now gives daily transparency on what they are holding as collateral but it also raises eyebrows when you see earlier this month iShares reporting more than a third of the collateral held for the FTSE 250 ETF securities lending programme is in Italian banking equities.’

Physical ETFs, which buy the underlying shares comprising the index, can engage in securities lending, whereby they loan out the ETF’s holdings in return for collateral and a fee.

iShares returns 60% of the revenue generated back into the fund, while it takes the remaining 40% as profit. The firm also points out that its securities lending is over-collateralised, with both loans and collateral marked-to-market on a daily basis.

Other ETFs – for example, the iShares Barclays Capital Euro Government Bond 7-10 - lends out on average 68% of its holdings over the year, returning 7.2 basis points to the fund.

At the other end of the scale, the iShares FTSE 100 only lends out 1% of its holdings, for a return of 0.8 basis points.

High demand

Generally, issuers can lend out securities in ETFs that track less liquid shares, as the return of the revenue can help offset tracking error and the costs incurred by the investor. Firms also lend out securities that are in high demand, but may not be as liquid as the FTSE 100.