I do not wear sandals or live with my mum, but I am more of a nerd in other ways, not least as I think that securities lending is one of the more interesting parts of the ETF world. As far as I’m concerned, securities lending plays a vital role in the hedge fund world, in the way that banks fund themselves, and it’s an important profit stream for some of the big ETF issuers.
Just what is securities lending?
At its heart, it is very simple. You have some equities or bonds in your portfolio. Rather than just letting them gather dust, you decide to make them work harder in order to gain a bit of extra revenue. To do this, you would probably have to hire an agent who would find someone who wants to borrow your securities – usually one of the big banks. The agent will negotiate your fee, the type of collateral you will receive, plus a little bit of extra collateral as a safety margin, or a ‘haircut’. And your agent usually takes a cut of your fee as commission.
When you lend, the security passes to your counterparty and you receive the agreed collateral equal to the value of the security you have loaned, plus the haircut. The collateral is marked-to -market daily so that collateral can be topped-up or returned as appropriate. Most loans are overnight, so you are not really inhibited in trading your security, you simply ask for it back so that you can trade it. It is really that simple.
Why do ETF providers lend?
Again an easy one. It’s done because they make money by acting as your agent. They seem to take around 30% of your fee for arranging your loan and maintaining the collateral. For the ETF issuers, it is a reasonably lucrative business, with little risk.
Why borrow securities?
There many reasons to borrow securities, but two major areas are to sell a security short and another area is to enter into a ‘collateral upgrade swap’. If you think a security that you do not own is going to fall, you can sell it and hope to buy it back later at a lower price. However, if you sell a security you do not own, you will need to have something to deliver to your counterparty. Short sellers, therefore, go to the security lending market and borrow their desired security. The cost can vary depending upon supply and demand and can move between a few basis points and many percent a year.
The collateral upgrade swap is a little more complex. Generally, the big banks need very high grade liquid bonds like gilts and US treasuries. Dodd Frank and the European Market Infrastructure Regulation rules, introduced since the 2008 Financial Crisis, mean that the large banks need a high-grade bonds for liquidity purposes and to post as margin with the central clearing counterparties for their OTC trades. Prior to the financial crisis nearly all OTC trades were unmargined, but now, post-crisis, nearly all of them are margined with high-grade bonds.
The big banks, therefore, borrow the bonds from lenders and post whatever assets they don’t immediately need as collateral. The collateral they post are often equities, which the big banks hold on their balance sheets as part of their investment trading activities.
It you look at it from the banks’ point of view they are upgrading their collateral, borrowing high-quality bonds and posting lower-quality equities. If you are a geeky owner of a gilt, or a gilt ETF say, it would be more precise to call it a collateral downgrade.
Passive investors, including ETF investors, supply something like 65% of the securities that are available to lend, particularly as there’s high demand for high-grade bonds. iShares’ excellent disclosures show that up to 95% of their gilt and US treasury ETFs are on loan earning around 0.10% a year for the ETF owners. That 0.10% may not sound like a lot, but it is enough to nearly double the yield on some government bonds.
iShares’ website also discloses what collateral is accepted in exchange for your high-grade bonds. Reviewing the collateral that replaces the gilts often has me reaching for my atlas and reaching for my Bloomberg to see what some companies actually do.
Personally, I find this fascinating: how your humble government ETF is magically transformed into stock in Apple or the oddly-named Members (ticker 2130 JT), to be used to finance the big banks or help hedge funds take short positions. It certainly beats my old trainspotting hobby and some of my friends now do not wear anoraks.