It is now widely understood by investors that securities lending in physically-replicated exchange-traded funds (ETFs) could pose counterparty and collateral risks similar to those inherent in the use of swaps in synthetic ETFs. Indeed, a recent survey of UK financial advisers found that six in ten advisers (62%) were concerned about the counterparty risks associated with securities lending.

Morningstar examined the securities lending practices of 10 major European providers as part of a comprehensive study into securities lending in physically-replicated ETFs.

This concern has led to regulators calling on ETF providers to improve the transparency around their securities lending practices.

Securities lending is the process of temporarily loaning securities to a third party in exchange for a fee. In the context of physically-replicated ETFs, lending out a fund’s holdings can help to partially, or in some cases completely, offset management fees and other sources of tracking error.

With some 45 per cent of physically-replicated ETFs in Europe now engaged in securities lending, analysts at Morningstar, a leading investment research and analytics provider, examined the securities lending practices at 10 major European providers as part of a comprehensive study into securities lending in ETFs.

Broadly, they found that transparency and safeguards had improved among some providers following investor concern, but that there was still room for improvement across the industry.

Details of the study can be found in their report, entitled Securities Lending in Physical Replication ETFs: A Review of Providers’ Practices. Key findings include:

• Regulatory scrutiny and investor pressure has delivered enhanced transparency among some providers; investors are now able to access more information on some provider websites, including the composition and amount of collateral received against securities loans, the maximum and average on-loan levels, and the net return to the fund generated via securities lending.
• Disclosure of counterparties’ identities remains subject to much resistance; the latest ESMA guidelines on ETFs and other UCITS will require a list of borrowers to be published once a year in the fund’s annual reports, forcing change.
• In response to concerns about counterparty risk, some providers have reviewed their lending programmes; as a result, some funds have stopped lending assets and others are now subject to limits on the amount of assets they can lend.
• An increased number of issuers provide indemnification or some other type of protection against borrower default, and more are expected to do so in the near future.
• In most cases, the portion of securities lending revenues returned to a fund ranges from 45 to 70 per cent of gross revenue; a few providers say they return 100 per cent of associated revenues, net of costs, but do not currently disclose these costs.
• There is no guarantee under the new ESMA guidelines that more money will be returned to fund shareholders; changes made to comply with the guidelines may be more a matter of semantics than economics, but will likely prompt fund providers to review their revenue sharing arrangements and re-evaluate whether fees currently charged are reasonable and justified.

Hortense Bioy, senior European ETF analyst at Morningstar and co-author of the report, said: “There has been much speculation in recent weeks about how the new ESMA rules on securities lending revenues will affect fund returns.

“As we expected, some providers have already taken action to return more income to investors, while others have said they won’t pass on any more income because they consider the fees they currently retain to be fair and reasonable. Ultimately, we hope that the additional transparency requirements, together with competitive forces, will help drive down the costs associated with securities lending, providing enhanced returns to investors.”