Generating extra returns

Securities lending can be an effective tool for ETF issuers to generate extra returns for investors, especially when demand is high for the underlying securities. The process of securities lending is a relatively straightforward one. 

Mechanics

An issuer will loan out the underlying securities of an ETF in exchange for collateral and a small fee. The fee will be determined by market demand. If the securities are in high demand, the borrower may want to pay a premium for the shares while securities in less demand will result in a lower yield.  

After a pre-agreed date, or when the lender asks, the borrower will send back the original basket to the issuer in exchange for the collateral which is typically limited to sovereign debt for UCITS ETFs. The lending agent is the entity which the borrower transfers the collateral to and is responsible for holding the securities, a service that the borrower pays a fee for. 

Dividends, voting rights and ESG considerations

When the securities are on loan, the borrower receives all dividends and distributions but is contractually obliged to pass them onto the lending agent which subsequently pays the lender. If the value of the underlying securities increase, the borrower will have to send additional collateral to the lender. 

However, the borrower does have the right to exercise any votes when the securities are on loan which has been an area of contention for ESG ETFs that engage in securities lending.

With the boom of ESG ETFs in Europe, many investors are laser-focused on seeing issuers engage with the companies they own. 

Lending out the securities to a third party would remove any voting rights and could encourage the short selling of ESG-friendly stocks.

Securities lending is considered standard practice in today’s ETF market, however, that does not mean the process is not without some risk. 

Risks and benefits

By partaking in securities lending, ETF issuers automatically introduce counterparty risk to the product which some investors are wary of in a post-Global Financial Crisis (GFC) era.

If the borrower of the underlying basket goes bust, the issuer will be left with the collateral which could be worth less than the value of securities on loan. 

Final word

It is important to remember securities lending has a crucial role in financial markets by enabling short-selling activities, facilitating the clearance of failed trades and providing liquidity to market makers.

Overall, the process is a positive for European financial markets and should be seen as a useful way of generating extra returns when investing in certain ETFs.