Get outta town
25 August 2015
It鈥檚 been a long, lonely winter for ETFs as collateral, but Markit鈥檚 newest initiative means many are shaking off their dowdy feathers and emerging as swans
Image: Shutterstock
Exchange-traded funds (ETFs) are the ugly ducklings of the collateral world鈥攕hunned, mistrusted and, overall, avoided.
But in a world where collateral is becoming scarce and efficiency is everything, many of these mallards are proving themselves to be not so ugly after all鈥攎any more are veritable swans.
The problem, until now, for collateral managers has been deciphering the bad eggs from the good, a time consuming and inefficient task. But in August, Markit released its ETF collateral lists function in order to take care of some of the hard work for collateral managers and encourage use of ETFs as securities lending collateral.
The lists filter ETFs and highlight those that track assets in short supply on the collateral market. They pick out fixed-income and equity ETFs that track liquid indexes in developed markets, and hide any subscale funds, and those that have a market value deviating more than 1 percent from the value of assets held. Essentially, they pre-select those ETFs that are suitable, and safe, for use as collateral.
It鈥檚 a simultaneously high-tech and simple response to reluctance from money market participants to accept ETFs as collateral. At Markit鈥檚 London 网爆吃瓜 Finance forum, 43.9 percent of attendees said they do not accept exchange-traded products (ETPs) as collateral, and 12.2 percent said they would like to, but cannot. Only 31.7 percent answered with a straight 鈥榶es鈥�, and the other 12.2 percent said they do accept ETPs as collateral 鈥渙n very few occasions鈥�.
Markit put this down to a lack of standardisation in the criteria of ETFs and a lack of transparency in the markets, as well as the lengthy management process for risk departments and triparty agents.
Mark Schaedel, managing director of indices at Markit, adds to this, saying that although collateral managers can see the benefit of ETFs, they are often deemed more effort than they鈥檙e worth.
He says: 鈥淥ne of the issues is that ETFs don鈥檛 meet that criteria for liquidity, but actually they鈥檙e misunderstood鈥攖hat measure is inappropriate for an ETF asset class.鈥�
鈥淐ollateral managers understand this, but the tedious process of having to evaluate and assess each fund individually is unmanageable. Therefore, the managers don鈥檛 bother, and ETFs remain underutilised.鈥�
On top of this, while ETFs may be generally desirable in the market, underutilisation has led to a reduced presence.
Andrew Jamieson, global head of broker-dealer and market-maker relationships for iShares at BlackRock, suggests that lenders have a perception that there isn鈥檛 demand from the buy side to put up ETFs as collateral, and conversely, borrowers don鈥檛 see the opportunity from lenders to pledge ETFs, either.
鈥淵ou end up having that self-fulfilling prophecy where people think there鈥檚 no supply and people think there鈥檚 no demand, and as a consequence, nothing much happens,鈥� he says.
鈥淭he Markit collateral filter process will bring a much greater transparency and an understanding of the product. Adoption by the triparty agents will also automate the process for the first time, making it much simpler, so it鈥檚 a win-win.鈥�
Even if collateral managers wanted to make proper use of ETFs, and if borrowers and lenders were on the same page, the process would have previously involved significant manual efforts to wheedle out those that are worth accepting or posting as collateral.
Keshava Shastry, head of ETP capital markets at Deutsche Asset & Wealth Management, says: 鈥淭here was a lot of manual work done on checking every ETF that had to be approved as collateral. Any initiative that helps to reduce the work and resource spent by collateral management teams, by outsourcing to an independent firm that then publishes a list of products meeting certain criteria, is helpful.鈥�
The new Markit tool removes some of the complication, facilitating the risk management normally conducted by the collateral taker.
Essentially, according to Jamieson, it鈥檚 鈥渁llowing a trusted third party to do a lot of the heavy lifting with regards to the initial due diligence鈥�.
Schaedel explains: 鈥淲e provide tools to analyse the fund compositions and their exposures.鈥�
He adds: 鈥淭hese tools can be used to further customise these collateral lists or to create new collateral lists, which we would be happy to publish as well.鈥�
For now, the solution is focusing on the European markets. Although use of ETFs has seen a slight increase in popularity in the region, and the consensus seems to be that the intentions are there, according to Markit鈥檚 data, utilisation is significantly lagging.
In the US, lendable ETF assets equate to about $90 billion, a figure that has doubled in the last five years, and utilisation levels tend to be between 20 percent and 40 percent. In Europe, however, the total figure for lendable ETF assets has stayed fairly flat for the last five years at $26 billion鈥攅ven seeing a decline of about 10 percent. Utilisation levels are consistently below 5 percent.
Schaedel says: 鈥淲hat we鈥檙e trying to do is stimulate securities lending in the European market. There is an untapped potential for using ETFs as collateral, and when it鈥檚 compared to the US market, it becomes clear that there is a link between the use of ETFs as collateral and the growth of AUM (assets under management).鈥�
The lists aren鈥檛 solely aimed at the European markets鈥攐nly, as Schaedel puts it: 鈥淭he campaign to raise awareness at the moment is focused on Europe.鈥�
Eventually, the function will affect funds all over the world, including those in Asia. But, the fact that the US and Europe are being used as the testing ground is, perhaps, only natural.
Steve Kiely, head of securities finance and new business development for the Europe, Middle East and Africa markets group at BNY Mellon, says: 鈥淣ew trends and trade types tend to be formulated in Europe or the US first, so it is natural that any development will take place there before being assimilated in Asia.鈥�
鈥淚 don鈥檛 believe the Asian market is anti-ETF, it鈥檚 just that they are still getting comfortable with equities, so it will take time before there is a natural progression to physical ETFs.鈥�
Shastry takes a similar, if inverse approach, suggesting that actually the listing processes should be finalised before they鈥檙e extended further afield.
He says: 鈥淭his is a work in progress. Over time there will likely be more collateral lists coming from independent parties that meet various criteria covering different requirements of collateral managers, as well as ETFs domiciled in various regions.鈥�
Jamieson takes an alternative viewpoint, citing the global nature of ETFs and the various exposures included. He calls the US 鈥�40 Act and the European UCITS range the 鈥渢wo major manufacturing hubs鈥� that represent domiciled funds used by investors worldwide.
He says: 鈥淎sian investors can typically buy globally listed products and gain exposure that way, so in terms of actual product usage, the US and the European product domiciles represent the vast majority of assets under management.鈥�
鈥淭he important point is that Asian clients are able to, and do readily, buy both UCITS and 鈥�40 Act products so they鈥檙e not disadvantaged in any way by the initial Markit filters focusing on these product domiciles. Therefore, hopefully the lists will encompass everything of interest to them.鈥�
What is interesting, and perhaps unusual, about this European 鈥榗ampaign鈥� is that it represents a fairly significant change in the culture of collateral that鈥檚 driven purely by market initiative and innovation, rather than by regulation borne from market risk or from dire necessity.
Jamieson suggests that this is partly because there hasn鈥檛 been a significant enough issue to justify regulatory oversight, because there is still plenty of collateral in the system, and not enough pressure to force the use of ETFs.
He says, however: 鈥淲hat the individual participants have felt is that they have an inefficiency around collateral that is not being utilised, and therefore commercial drivers have really pushed this forward.鈥�
Ultimately, it is in commercial interest to all securities lending players to tap in to a new kind of collateral, and to increase the total figures of AUM. According to Shastry, it鈥檚 not necessarily something that falls under the regulators鈥� responsibility. He says: 鈥淲e are being proactive in addressing this, and once there is some momentum hopefully others will follow.鈥�
In more specific terms, Kiely says: 鈥淭he solution is in the interests of all market participants and maybe the answer is in being more imaginative with this type of trade. For example, if 107 percent is the standard margin for equity versus equity, maybe ETFs could reach 110 or 112 percent.鈥�
鈥淚t is the responsibility of all protagonists to explore potential routes to market, and the financing of ETFs and their general use as a collateral asset class is something that should be widely discussed.鈥�
As far as Schaedel is concerned, however, the initiative is not only not mandated by the authorities, but successful by virtue of being industry-led. Rather than a reaction to market failures, the solution has come about from a roundtable of ETF market players and several discussions to determine the common objectives, and which are the most pressing.
A solution coming from within the industry promises to be organically suited to that industry and, perhaps more importantly, one that all participants will be likely to get behind. Schaedel says: 鈥淚t鈥檚 a thought leadership exercise, really. But it has got a great deal of support from the market, and we feel like everyone鈥檚 intentions are very much aligned. The things that we can change, we are trying to. Those that we can鈥檛鈥攖hat require more regulatory support鈥攁re still meaningful, but we choose to focus on things we can really be proactive on. And with this, the market is ready to engage, too.鈥�
But in a world where collateral is becoming scarce and efficiency is everything, many of these mallards are proving themselves to be not so ugly after all鈥攎any more are veritable swans.
The problem, until now, for collateral managers has been deciphering the bad eggs from the good, a time consuming and inefficient task. But in August, Markit released its ETF collateral lists function in order to take care of some of the hard work for collateral managers and encourage use of ETFs as securities lending collateral.
The lists filter ETFs and highlight those that track assets in short supply on the collateral market. They pick out fixed-income and equity ETFs that track liquid indexes in developed markets, and hide any subscale funds, and those that have a market value deviating more than 1 percent from the value of assets held. Essentially, they pre-select those ETFs that are suitable, and safe, for use as collateral.
It鈥檚 a simultaneously high-tech and simple response to reluctance from money market participants to accept ETFs as collateral. At Markit鈥檚 London 网爆吃瓜 Finance forum, 43.9 percent of attendees said they do not accept exchange-traded products (ETPs) as collateral, and 12.2 percent said they would like to, but cannot. Only 31.7 percent answered with a straight 鈥榶es鈥�, and the other 12.2 percent said they do accept ETPs as collateral 鈥渙n very few occasions鈥�.
Markit put this down to a lack of standardisation in the criteria of ETFs and a lack of transparency in the markets, as well as the lengthy management process for risk departments and triparty agents.
Mark Schaedel, managing director of indices at Markit, adds to this, saying that although collateral managers can see the benefit of ETFs, they are often deemed more effort than they鈥檙e worth.
He says: 鈥淥ne of the issues is that ETFs don鈥檛 meet that criteria for liquidity, but actually they鈥檙e misunderstood鈥攖hat measure is inappropriate for an ETF asset class.鈥�
鈥淐ollateral managers understand this, but the tedious process of having to evaluate and assess each fund individually is unmanageable. Therefore, the managers don鈥檛 bother, and ETFs remain underutilised.鈥�
On top of this, while ETFs may be generally desirable in the market, underutilisation has led to a reduced presence.
Andrew Jamieson, global head of broker-dealer and market-maker relationships for iShares at BlackRock, suggests that lenders have a perception that there isn鈥檛 demand from the buy side to put up ETFs as collateral, and conversely, borrowers don鈥檛 see the opportunity from lenders to pledge ETFs, either.
鈥淵ou end up having that self-fulfilling prophecy where people think there鈥檚 no supply and people think there鈥檚 no demand, and as a consequence, nothing much happens,鈥� he says.
鈥淭he Markit collateral filter process will bring a much greater transparency and an understanding of the product. Adoption by the triparty agents will also automate the process for the first time, making it much simpler, so it鈥檚 a win-win.鈥�
Even if collateral managers wanted to make proper use of ETFs, and if borrowers and lenders were on the same page, the process would have previously involved significant manual efforts to wheedle out those that are worth accepting or posting as collateral.
Keshava Shastry, head of ETP capital markets at Deutsche Asset & Wealth Management, says: 鈥淭here was a lot of manual work done on checking every ETF that had to be approved as collateral. Any initiative that helps to reduce the work and resource spent by collateral management teams, by outsourcing to an independent firm that then publishes a list of products meeting certain criteria, is helpful.鈥�
The new Markit tool removes some of the complication, facilitating the risk management normally conducted by the collateral taker.
Essentially, according to Jamieson, it鈥檚 鈥渁llowing a trusted third party to do a lot of the heavy lifting with regards to the initial due diligence鈥�.
Schaedel explains: 鈥淲e provide tools to analyse the fund compositions and their exposures.鈥�
He adds: 鈥淭hese tools can be used to further customise these collateral lists or to create new collateral lists, which we would be happy to publish as well.鈥�
For now, the solution is focusing on the European markets. Although use of ETFs has seen a slight increase in popularity in the region, and the consensus seems to be that the intentions are there, according to Markit鈥檚 data, utilisation is significantly lagging.
In the US, lendable ETF assets equate to about $90 billion, a figure that has doubled in the last five years, and utilisation levels tend to be between 20 percent and 40 percent. In Europe, however, the total figure for lendable ETF assets has stayed fairly flat for the last five years at $26 billion鈥攅ven seeing a decline of about 10 percent. Utilisation levels are consistently below 5 percent.
Schaedel says: 鈥淲hat we鈥檙e trying to do is stimulate securities lending in the European market. There is an untapped potential for using ETFs as collateral, and when it鈥檚 compared to the US market, it becomes clear that there is a link between the use of ETFs as collateral and the growth of AUM (assets under management).鈥�
The lists aren鈥檛 solely aimed at the European markets鈥攐nly, as Schaedel puts it: 鈥淭he campaign to raise awareness at the moment is focused on Europe.鈥�
Eventually, the function will affect funds all over the world, including those in Asia. But, the fact that the US and Europe are being used as the testing ground is, perhaps, only natural.
Steve Kiely, head of securities finance and new business development for the Europe, Middle East and Africa markets group at BNY Mellon, says: 鈥淣ew trends and trade types tend to be formulated in Europe or the US first, so it is natural that any development will take place there before being assimilated in Asia.鈥�
鈥淚 don鈥檛 believe the Asian market is anti-ETF, it鈥檚 just that they are still getting comfortable with equities, so it will take time before there is a natural progression to physical ETFs.鈥�
Shastry takes a similar, if inverse approach, suggesting that actually the listing processes should be finalised before they鈥檙e extended further afield.
He says: 鈥淭his is a work in progress. Over time there will likely be more collateral lists coming from independent parties that meet various criteria covering different requirements of collateral managers, as well as ETFs domiciled in various regions.鈥�
Jamieson takes an alternative viewpoint, citing the global nature of ETFs and the various exposures included. He calls the US 鈥�40 Act and the European UCITS range the 鈥渢wo major manufacturing hubs鈥� that represent domiciled funds used by investors worldwide.
He says: 鈥淎sian investors can typically buy globally listed products and gain exposure that way, so in terms of actual product usage, the US and the European product domiciles represent the vast majority of assets under management.鈥�
鈥淭he important point is that Asian clients are able to, and do readily, buy both UCITS and 鈥�40 Act products so they鈥檙e not disadvantaged in any way by the initial Markit filters focusing on these product domiciles. Therefore, hopefully the lists will encompass everything of interest to them.鈥�
What is interesting, and perhaps unusual, about this European 鈥榗ampaign鈥� is that it represents a fairly significant change in the culture of collateral that鈥檚 driven purely by market initiative and innovation, rather than by regulation borne from market risk or from dire necessity.
Jamieson suggests that this is partly because there hasn鈥檛 been a significant enough issue to justify regulatory oversight, because there is still plenty of collateral in the system, and not enough pressure to force the use of ETFs.
He says, however: 鈥淲hat the individual participants have felt is that they have an inefficiency around collateral that is not being utilised, and therefore commercial drivers have really pushed this forward.鈥�
Ultimately, it is in commercial interest to all securities lending players to tap in to a new kind of collateral, and to increase the total figures of AUM. According to Shastry, it鈥檚 not necessarily something that falls under the regulators鈥� responsibility. He says: 鈥淲e are being proactive in addressing this, and once there is some momentum hopefully others will follow.鈥�
In more specific terms, Kiely says: 鈥淭he solution is in the interests of all market participants and maybe the answer is in being more imaginative with this type of trade. For example, if 107 percent is the standard margin for equity versus equity, maybe ETFs could reach 110 or 112 percent.鈥�
鈥淚t is the responsibility of all protagonists to explore potential routes to market, and the financing of ETFs and their general use as a collateral asset class is something that should be widely discussed.鈥�
As far as Schaedel is concerned, however, the initiative is not only not mandated by the authorities, but successful by virtue of being industry-led. Rather than a reaction to market failures, the solution has come about from a roundtable of ETF market players and several discussions to determine the common objectives, and which are the most pressing.
A solution coming from within the industry promises to be organically suited to that industry and, perhaps more importantly, one that all participants will be likely to get behind. Schaedel says: 鈥淚t鈥檚 a thought leadership exercise, really. But it has got a great deal of support from the market, and we feel like everyone鈥檚 intentions are very much aligned. The things that we can change, we are trying to. Those that we can鈥檛鈥攖hat require more regulatory support鈥攁re still meaningful, but we choose to focus on things we can really be proactive on. And with this, the market is ready to engage, too.鈥�
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