No Shortage Of Share Lending
By Leonard Welter

Since their inception over nine years ago, the assets of European-listed exchange-traded funds have grown to a record $223 billion.¹ The rapid recent growth of the European ETF market indicates that ETFs have obtained acceptance as an asset allocation tool by institutional as well as retail investors. The securities lending market for European-listed ETFs also saw an increase in 2009, with loan values recovering from their spring lows. The lending market also saw an increase in the breadth of trading throughout 2009, and by December there were more than 300 different ETFs with securities lending activity in Europe.² Could this be the year the securities lending market for European ETFs really takes off?

Securities lending is a global market with more than $1 trillion worth of equity assets out on loan.³ The main purpose of the market is to facilitate the practice of short selling—a short seller is required to borrow the security in order to make onward delivery to the market. The lender of the security negotiates the price to borrow, with this price generally being quoted as an annual percentage of the value of the loan, while retaining the right to recall the loaned security at any time. The loans are collateralized with either cash or securities and are governed by standard agreements.

The securities lending market is relatively complex and the majority of transactions take place over the counter (OTC). The supply of securities that are made available to the lending market comes from beneficial owners, such as pension funds, who make their shares available to lend via agents such as custodian banks. The demand to borrow is fueled by hedge funds and proprietary trading desks that use either internal trading desks or prime brokers to source and manage their borrowing requirements.

In the United States, the lending and borrowing of ETFs has been well established for many years. ETFs such as SPY and QQQQ are very easily borrowed by short sellers who are taking directional views on the market or are using them as a relatively cheap and easy way to manage a hedge. It can be argued that the activity of short sellers in the ETF market helps to provide market liquidity and trade volume for the largest ETFs in the U.S. market. There is an additional benefit to the underlying holder of loaned ETFs, as the lending revenue can offset some, or all, of the management charge of the fund, which reduces their tracking error to the benchmark of the ETF.

In Europe, the securities lending market has seen much slower growth when compared with the U.S. The slow growth has been due to several factors, all of which come down to the classic problem of “which came first: the chicken or the egg?” or, in the case of lending European ETFs, “which came first: supply or demand?”

Supply has historically been an issue for ETF securities lending, as the traditional lenders such as custodian agents either did not have accounts holding ETFs or they did not understand the structure and nature of ETFs and therefore did not lend them.

Another disadvantage European ETFs have when compared with their U.S. counterparts is the structural cost of creation. In the U.S., ETF supply for lending could be created relatively easily, by borrowing the underlying constituents of the ETF and delivering them to the creation agent in return for ETF units, which could then be lent to the market. This cost of creation is generally low, which means that the “borrow to create” (or “create to lend”) ETF transaction is a viable source of supply. In Europe, on the other hand, stamp taxes and dividend costs make the “borrow to create” transaction prohibitively expensive to the short seller and lending agents.

Demand has historically also been an issue for the European ETF securities lending market. Hedge funds and proprietary trading desks can easily substitute a trade that involves the shorting of an ETF by entering into a swap contract. A swap can be structured to give the same performance of a short ETF position and has been seen to be a less expensive and more stable alternative to borrowing ETFs. The recall risk when borrowing ETFs can be significant, as the general lack of supply mean’s that a hedge or directional short could be forced to close due to the lender requiring the return of borrowed shares.

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