Exchange Traded Funds (ETFs) have gained increasing popularity amongst investors, with global ETF investments outperforming hedge fund investments in the second quarter. Positive investment patterns, however, have not yet translated into wider acceptance within the collateral management context. Last month, Markit launched ETF Collateral Lists in a bid to bridge the gap between ETFs and securities lending collateral. Markit’s Pierre Khemdoudi, managing director of Securities Finance, and Anthony Kruger, ETF Product Specialist, discuss the launch of the Collateral Lists and the growth of ETFs.
Can you explain what these ETF collateral lists are?
AK: We have published two lists; one is the collateral physical fixed income, and the other is collateral physical equity. These are meant to be quite high level and conservative in nature, but we don’t think we are pushing the needle too much in what is accepted currently. We are just making the process more efficient so the type of ETFs you find in each list tend to be accepted as collateral by those certain lenders.
PK: In a time where people are optimising their balance sheet and trying to make use of every single asset in terms of collateral management, ETFs seems to be the asset class that is not being as widely used. This is mainly due to a lack of risk/manual processes of evaluating and classifying the ETFs. This initiative looks to standardise management of ETFs and help market participants to integrate ETFs into their collateral management flows.
PK: When you look at the metrics of deploying collateral, you look at the asset class; its scope and geography. When it comes down to equities you refer to the FTSE 100, and everybody knows what is in the FTSE 100 so that gives you a nice one liner to integrate equities. But at present the process to accept ETFs as collateral is actually a line-by-line process. So classification is more complex. However with our initiative, you are not looking at it line-by-line but rather using a rule-based methodology to integrate ETFs. So with this methodology you can integrate several assets and make your management of ETFs more efficient.
What market participants are demanding increased use of ETFs as collateral?
AK: Demand is coming from both beneficial owners and asset managers. It is also from the broker-dealer community. In Europe market makers at the moment cannot make efficient use of ETFs in the repo market. They then may pass on that additional cost in their bid-ask spread. This could discourage investors because their total cost of ownership in getting into the product is higher than other products. So there is definitely a demand for the broker-dealers to post ETFs as collateral.
PK: Also as ETFs continue to grow very rapidly, more beneficial owners will end up holding these, and would want to lend them to gather added revenue. This could lead to ETFs becoming “fully fledged” financial instruments where you can go long and short or used for hedging strategies etc.
What types of firms will have to stand up for ETFs to become widely accepted?
AK: It is an industry-wide initiative. It will be led a lot by the agent lenders who will be facilitating the use of these for their clients. So I think it will come down to them to promote it, but it is also key that we are integrating into the tri-party agents to really help the operational efficiency of ETFs to go forward.