Securities lending allows ETFs to generate additional income, thereby reducing overall costs for investors. But investors should also be aware of the risks.
• A profitable triangle trade
• Increased margin for issuers
• Focus on safety nets
The mechanism of securities lending
Securities lending is a well-established practice in which an ETF, as the beneficial owner, temporarily transfers certain securities from its portfolio to a counterparty, such as a bank or broker. In this process, a specialized lending agent often acts as an intermediary who coordinates the transaction, negotiates the lending fees and handles the daily valuation of the positions. Overall, a triangular dynamic is created in which everyone involved can benefit from the trade.
The borrower often needs these securities to meet delivery obligations, conduct short sales, or implement complex arbitrage strategies. During the term of the loan, all economic claims, such as dividends or interest income, remain with the lender in the form of replacement payments, while the borrower must provide security in return. This collateral usually consists of cash or other highly liquid securities and typically exceeds the value of the securities borrowed to provide a buffer against market fluctuations. At the end of the term, as UBS explains, the borrower is obliged to return the identical number and type of securities, after which the ETF regains full control over the securities.
Advantages and challenges for issuers
For issuers of ETFs, securities lending is an important tool, as Schwab Asset Management writes, to increase the competitiveness of their products through optimized performance. Through the income from lending transactions, fund companies can effectively reduce the product’s internal expense ratio or even outperform the benchmark index. This is a crucial factor in attracting investors, especially in highly competitive markets, as the income generated can flow directly into the fund’s net asset value. However, as UBS emphasizes, this process also entails significant operational obligations for the issuer, as it must ensure continuous monitoring of counterparties and strict compliance with regulatory requirements such as the UCITS Directive. There is also a reputational risk for the issuer if the selection of borrowers or the management of collateral is not carried out with the necessary care.
Advantages and risks for investors
Investors benefit from securities lending primarily through a higher net return, which is often visible through a reduction in the so-called tracking error, as ETF.com explains. In some cases, lending returns can be so substantial that they fully offset the ETF’s management fees or, in niche sectors with high demand for lending securities, even provide exceptional additional dividends. This means that lending acts as an efficient tool for portfolio optimization without the investor having to take any action themselves. However, there is a minimal residual risk, which primarily concerns the counterparty risk, should a borrower become insolvent and the value of the collateral provided decrease at the same time. Another potential risk is reinvestment risk if the Fund invests the cash collateral received in money market instruments, which in turn could lose value. Although modern security mechanisms such as overcollateralization of usually 102 to 105 percent and daily mark-to-market valuations drastically reduce these risks, securities lending remains a process that requires careful due diligence of the ETF provider by the investor, as UBS and Schwab agree.
Regulatory safety nets in comparison
The security of securities lending is largely determined by the respective jurisdiction of the fund’s domicile, although European and US standards pursue similar goals, but vary in detail. In the European Union, ETFs are subject to the strict UCITS directive, which requires, for example, that collateral must be highly liquid and the ETF must retain the right to reclaim the securities lent at any time without notice. Similar FINMA rules apply to funds domiciled in Switzerland, which can provide for additional discounts on the value of the collateral in order to further increase stability.
In the United States, however, funds operate under the Investment Company Act of 1940, which imposes specific requirements for holding collateral and investing cash in regulated money market funds. While US funds often use a collateralization of 102 percent for domestic securities, both regulatory worlds usually require a buffer of 105 percent for international transactions. These tight regulations ensure that securities lending, despite its theoretical risks, is in practice considered a conservative and highly controlled method of increasing returns.
Markus Maier, editorial team at finanzen.net
By the way: Franklin Resources and other US stocks can even be traded on finanzen.net ZERO until 11 p.m. (without order fees, plus spreads). Open a depot now for free and secure a new customer bonus!
Selected leverage products on Deutsche Börse
With knock-outs, speculative investors can participate disproportionately in price movements. Simply select the leverage you want and we will show you suitable open-end products on Deutsche Börse
The leverage must be between 2 and 20
Advertising