Developing the post-trade environment for ETFs as well as the accessibility of using ETFs as collateral could be vital to the future growth of the ETF market, according to a recent study by PwC.
The report, entitled ETFs: Unlocking further potential, highlights how the European ETF market has grown significantly in recent years and is looking like it will continue to grow despite the fragmented nature of the market.
Some of the factors that have helped the market grow include various market and regulatory developments. However, PwC says there remain several other critical factors that could prevent the smooth execution of ETF trading in European markets.
Some issues which PwC believes need to be resolved include addressing the current lack of ETF specific rules and some of the nuances of ETFs – such as transparency, venue choice, clearing and settlement. Additionally, there needs to be further protection introduced for investors to enable them to make better choices.
PwC selects four aspects of the trading infrastructure in the European ETF industry which may require attention. These aspects include transparency, venue choice, post-trade environment and ETFs for collateral and lending.
The European Commission created the Capital Markets Union (CMU) to reduce the fragmentation issues such as strengthening cross border capital flows and access to finance for businesses.
The fragmented nature of the European ETF sector is reflected by its multiple markets and currencies which has resulted in barriers being made to an integrated capital market, says PwC.
Existing framework for ETF trading, clearing and settlement has become challenging as a result of European issuers being regionally focused and cross listing their products on multiple exchanges and in various currencies.
“The flexibility that ETFs can offer is not always supported by the sector’s underlying market infrastructure,” the report says.
These factors mean there is potential for increased fragmentation because of the increased use of different ETF trading venues post-MiFID II. As a result, investors could face higher trading costs.
PwC says this issue could be resolved by improved harmonisation in clearing which could also result in further ETF growth.
There is also the challenge of settlement within the post-trade environment as the European Central Securities Depository Regulation (CSDR) is set to be introduced on 1 February 2021. CSDR aims to harmonise the different rules applying to central securities depositories (CSDs) in Europe and to create an integrated market for securities settlement for both national and cross-border transactions.
The UK has announced, however, that it will not be adopting the European CSDR post Brexit which could have some implications.
ETFs for collateral
With a global securities lending market reaching €2.3trn at the end of 2019, investors are looking at using ETFs for more than just their long-only strategies as well as banks and CCPs are growing in acceptance of ETFs as collateral.
Supporting these commercial uses of ETFs has the potential to maximise returns for investors, says PwC. ETF units could provide opportunities for tactical portfolio management as well as a diversified asset base and a second layer of liquidity.
This is because the holder can sell the ETF on the secondary market or alternatively, redeem the ETF with its issuers via an authorise participant in exchange for its underlying securities or cash.
An issue ETFs face in acting as collateral is that they often do not meet all the criteria required for the single security regulatory framework. This is because the framework was designed without the structure of ETFs in mind and oversee the fact that the underlying securities for ETFs are accepted as collateral.
A solution PwC suggests for this is by using a “look through “approach whereby banks can look at the liquidity of the underlying stocks.
ETFs for lending
The securities lending market has also grown in recent years, reaching $2trn in 2019. While it is common for the lending of the underlying securities within ETF portfolios, PwC highlights how the lending of ETF units is still not seen as common practice.
Globally, some $62.6bn of ETF assets were out on loan in April 2020. In Europe alone, only 5% of lendable ETF units were on loan.
The report says that the lending of ETF units has the potential to enhance price stability and reduce spreads which means driving more efficiency for the end investor.
There lacks availability of information to support the growth of ETF borrowing and lending, according to the firm. The enhancement of this market could be assisted by the improvement of available data.
In tandem with improving the accessibility of this market for investors, they should also be made aware of the risks associated with the lending of ETF units.
The report says: “Considerations include the interaction between the lending by ETFs of their underlying portfolio of assets and the lending of the ETF units by ETF investors.
“However, the potential for lending ETF units to generate additional yield for ETF investors is significant, particularly with investors focused on driving recovery in returns post the COVID-19 crisis.”