As the exchange traded fund industry expands, it will inevitably face some growing pains along the way. For instance, some foreign regulators are beginning to take a closer look at the way ETF providers generate extra cash on the side through securities lending.
While not a pressing subject in the U.S., international regulators have voiced concerns that the lending practices could hurt investors and the financial systems, reports Ari I. Weinberg for The Wall Street Journal. Specifically, most critics contend that the practice poses counterparty risk where a default of the security’s borrower could leave the ETF provider in a short squeeze.
Nevertheless, market observers argue that most U.S.-listed ETFs are hardy enough to withstand any potential risks associated with securities lending. The Investment Company Institute believes that the risks associated with securities lending are “far more widespread in other investment vehicles,” compared to ETFs.
Funds engage in securities lending as a way to generate extra revenue. The holder temporarily transfers the security to another investor in exchange for collateral, such as cash or other securities equal to 102% to 105% of the shares’ value. If the ETF needs to sell stock, it can take it out of the borrower. If the borrower is unable to deliver the shares, the ETF uses the collateral.
For ETFs, institutional investors can lend out their shares of an ETF, or the ETF provider can lend shares of the underlying securities from the fund.
Most borrowers, typically institutional investors, would implement short positions with the shares, buy them back when the price dips and return the borrowed shares to the ETF at a profit.
ETF investors should note that securities lending is not something new or solely found in ETFs – institutional investors and funds have utilized the strategy more prolifically. Additionally, current regulations state that no more than one-third of a fund’s total assets can be loaned out, and ETFs have been more conservative in lending than other funds.
Moreover, some fund providers, like BlackRock, have stated that they will compensate funds and protect investors from financial loses if a company that borrows stocks goes bust, reports Emma Dunkley for Citywire.
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.