Why aren’t ETFs widely accepted as collateral?

Aug 7th, 2015 | By | Category: ETF and Index News

The exponential growth of assets invested in exchange-traded funds (ETFs) has been one of the most significant developments in financial markets in recent years. In Europe, however, wide acceptance of ETFs in the investment community has not translated into wide acceptance or use of ETFs in collateral management.

Why aren't ETFs widely accepted as collateral?

Wider acceptance of ETFs as collateral has the potential to lower fees and improve liquidity.

According to financial information services company Markit, over 55% of delegates at their recent Securities Finance forum stated that they didn’t accept or post ETFs as collateral, despite many of these ETFs being tied to assets which are readily acceptable as collateral.

Improving the use of ETFs as collateral in Europe has the potential to reduce fees, increase liquidity and reduce bid-offer spreads.

To facilitate this, Markit have launched their ETF collateral lists which aim to highlight ETFs that track assets which are already widely accepted as securities-lending collateral.

The demand for collateral is increasing due to regulations such as MiFID II and Dodd-Frank which require additional margins to be posted in derivatives transactions. The acceptance of ETFs as collateral will address possible supply issues, but there are challenges to achieving this.

Despite holding many characteristics which would classify them as high-quality collateral, many market participants don’t accept ETFs as they often fail liquidity and diversification tests which overlook the unique ETF structure.

There is a perception that ETF liquidity is low and this affects practitioners’ willingness to accept the assets as collateral. When assessing the liquidity of ETFs there are a number of considerations that need to be taken into account beyond the volume of shares traded on the exchange. Due to their unique creation and redemption process, ETF liquidity is directly tied to the underlying holdings, and this needs to be factored in when determining true ETF liquidity.

There are also issues around the number of ETF shares which are traded over-the-counter and not declared. MiFID II, which comes into force across Europe from 2017, requires these trades to be reported and will provide greater transparency into ETF liquidity.

Physically replicated ETFs are often linked to a diversified portfolio of stocks and bonds and a significant portion of these underlying assets are highly liquid. If liquidity and diversification tests gave greater attention to the underlying holdings, rather than assessing the asset as an individual holding, acceptance levels would be much higher.

In the event that the collateral needs to be liquidated, it can be sold in the secondary market. Failing this, the underlying holdings or a cash equivalent can be redeemed from the ETF liquidity provider, known as the authorised participant. This second layer of liquidity, coupled with a diversified asset base, characterise ETFs as a reputable source of collateral.

According to Markit: “European ETFs tend to not be adequately classified, which means evaluations for liquidity and diversification frequently must be done on a case by case basis. This process becomes onerous for risk departments that approve and maintain updated parameters for input into collateral agents’ systems. As a consequence, the cost of holding an ETF is often punitive compared to holding an ETF’s underlying bonds, equities or commodities. The higher cost can impact ETF trading spreads.”

The Markit ETF collateral lists provide a solution to this challenge by providing market participants with easily referenced lists of equity and fixed income ETFs that meet generally acceptable criteria for use as collateral. The lists are generated through a robust quality assessment which filters 6,000 global ETFs on seven criteria; geographic exposure, asset class, benchmark, leverage ratio, holding type, AUM and tracking difference.

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