Securities lending and repurchase transactions

What are securities Lending?

Securities lending is an efficient portfolio management technique according to ESMA’s guidelines on ETFs and UCITS. This technique is also known as commodities lending. Although not everyone is familiar with it, it is a technique that has been widely developed by ETF managers. It is performed on both physical and synthetic ETFs. However, it is more developed in physical replication of ETFs. This is because in physical replication, the securities that make up the ETF are owned. This technique is also developed in active portfolio management, although here the focus is on passive portfolio management.

Securities lending is a contract between the ETF manager, lender, and a third party, borrower. The lender then gives securities from the ETF portfolio to the third party in exchange for a fee. In addition to collecting this fee, the lender also receives collateral from the borrower. This collateral may be a pool of other securities or cash. The purpose of the collateral is to guarantee flows for the lender if the borrower does not return the borrowed securities. It is therefore justified because the loan itself involves counterparty risk. This risk arises from the situation of default by the counterparty.

Counterparty risk

The main concern is to address the potential situation where the borrower does not return the ETF´s securities. Therefore it’s key to know the solvency of the borrower to avoid its default. But not only that, it is also necessary to assess the quality and liquidity of the collateral provided. In case of the default the ETF expects to continue to earn the same return as before. This requires that the collateral is of the same quality and liquidity as the securities it has transferred. In fact, nowadays, it goes one step further and the phenomenon of over-collateralization is occurring. This means that the securities being lent are actually more than 100% collateralized. Thus, the value of the assets that make up the collateral is greater than the value of the securities transferred.

There is an additional risk called market risk. This risk is caused by the reinvestment of the collateral by the manager. So, the manager takes the cash or securities given as collateral and reinvests them to obtain a higher return. However, this reinvestment may not obtain a positive return; it is subject to the action of the market.
To limit the risks, ESMA stipulates that the loan can be terminated at any time. This implies that the fund may recover the securities lent at any time.

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Actions to mitigate counterparty risk

To mitigate counterparty risk, investment fund managers can take several actions.
Firstly, it is necessary to implement counterparty selection criteria. That is, to ensure that the counterparty meets minimum solvency requirements. In practice, termination clauses are included in case the solvency during the contract does not meet these requirements.
Secondly, also it is necessary to use criteria for the selection of the collateral. The aim is to ensure the quality of the assets as collateral and their liquidity. This is a problem when there are massive redemptions by the participants. In that situation, if the securities are borrowed, the fund must have enough liquidity to pay all of them at once. Therefore, it is crucial to ensure at least the equivalence of liquidity between the collateral and the securities lent.

Thirdly, it is recommended that possible extraordinary guarantees be implemented. The contract should state a solution for when the value of the collateral depreciates. If it does, while the contract is in force, there could be the aforementioned liquidity problems. Therefore, the contract may establish that if this happens, extraordinary guarantees may be demanded from the borrower. To ensure that this depreciation is known, the use of a centralized information system is also recommended. In this system the value of the loan and the value of the collateral shall be collected daily and updated. Due to the work involved in the latter function, loan agents are used as intermediaries in this operation. This task can be performed by the securities custodian.

In practice, all these actions are implemented to a greater or lesser extent by ETF providers.

Percentage of the loan

Depending on the origin of the fund, these loans will be governed by one or another regulation. However, all the regulations are moving towards the same goal. That objective is to allow securities lending but limit its risks.

The EU UCITS Directive, Version V of which came into force in 2014, sets a limit on securities lending. Thus, only 10% of securities may be exposed to the same counterparty. Counterparty risk is therefore limited for European UCITS ETFs. However, the same directive allows 100% of the securities making up the ETF to be lent. Thus, considering the two rules, if all the securities were to be lent, there would be a minimum of 10 counterparties. By contrast, under US law, only 50% of the ETF’s securities can be lent.

In practice, however, the managers limit themselves to the percentage they can lend. Managers generally have two options as to what percentage to lend and what to lend. One, they could lend the harder securities to be obtain in the market, thus involving a higher fee to charge. Two, they could lend a lot of securities to possibly obtain a higher income. For example, one of the largest ETF providers, iShares, chooses to lend as maximum the 50% of ETF´s securities. This maximizes both options, lend enough securities and lend the ones that produce a higher income.

Benefits of Securities Lending

ESMA guidelines provide that income from securities loans should be passed on to its participants. This is an obligation for the fund managers. However, it is said that such income is passed on after operating expenses have been deducted. But the directive does not set a percentage limit on such expenses, nor does it say what they are. So, in fact, from these securities loans two incomes are divided, one for the manager and one for the fund. However, some ETF providers such as Vanguard return almost 100% of this income to the investor, e.g. 98%. This profit for the investors is reflected in the fund’s net asset value.

The income from these loans is the main reason for the low ETF management fees. Their additional return is used to reduce these costs. This is a benefit for fund participants, because access to the funds is democratized. Moreover, as J.Bogle stated, low fees mean that in the long term the return of the fund will be higher. Therefore there are two kinds of benefits for the investor. On one hand, a direct benefit due to the lower cost of access to the fund. On the other hand, an indirect benefit due to the higher returns in the long term.

In addition, transparency about these contracts is provided for the benefit of the participant. Thus, all information on such loan proceeds can now be found in reports to investors. This is an obligation in Spain for ETFs according to CMNV Circular 2/2013. These data will also be found on the websites of each provider so participants could consult them. In fact, as the fund’s risks are set out in the prospectuses, securities lending will be included in them. Furthermore, last month, e.g., the management company DW8 included this operation in the ETF UCITS´s KIID.

What are repos?

ESMA calls them repurchase transactions. They consist of a sale and purchase agreement with a repurchase agreement. Depending on whether the transaction is viewed from the seller’s or the buyer’s perspective, it is called repo or reverse repo.

In the transaction, the buyer gives cash and in return receives collateral from the counterparty. This counterparty, the seller, will repurchase this collateral in the future by delivering the cash plus interest. The parties agree in advance on both the initial purchase price and the repurchase price by the seller. For the formulation of that price, it is agreed to apply a certain interest rate to the initial price. Thus, these operations have an almost non-existent risk due to this knowledge and a guaranteed but minimum return. The return will not be high because then the counterparty would not be interested in making the transaction. The financial asset, collateral, that is assigned is usually a fixed-income security, specifically public debt. As in securities lending, this collateral is used to mitigate the counterparty risk. Although this involves two parties there could tri-party repos, which involves a custodian bank for the collateral.

A key to these operations is that they have a short-term maturity. There could be repurchase transactions that are made overnight. On the other hand, there are repurchase transactions that can have a maturity of several months. The ESMA guidelines for ETFs also require the possibility of early maturity of the transaction. This means that at any time either party can demand the operation termination and its return to its original status. It even demands that this requirement be met for transactions with a maturity of less than 7 days. However, when this occurs there will be a penalty which translates in lower interest for the original buyer.

Difference with a buy-sell back transaction

Buy-sell back transactions as well as repurchase transactions are defined in Regulation (EU) 2015/2365. Buy-sell back transactions consist of making two sales and purchase agreements with the opposite sign. The maturity date and the future purchase price are therefore agreed in advance. In this case the profit is determined by the difference in prices which are independent of an interest rate.

For practical purposes, there are two differences. One, in repos, it may be established that during the contract the values delivered as collateral will be changed. The collateral seller shall recover the values that make up the collateral and replace them with others of equal quality. Two, in repos the yields of the securities transferred must be returned to the seller. That is, the coupon of the bond will be transmitted to the original seller.

Therefore, in buy-sell back transactions the complete power of disposal of the assets is transferred, not allowing its change. In this way the temporary buyer benefits doubly. During the duration of the operation he will obtain all the coupons of the collateral and at its maturity he will obtain the price differential.

Difference between Securities Lending and Repos

As we have seen, both securities lending and repurchase transactions are agreements whereby securities are exchanged between two parties. However, there is a difference in legal ownership. In the case of securities lending, the political rights of the securities are transferred. The lender could not exercise its voting rights, unless it expressly states otherwise in the contract. Generally, the same is established for securities lending as for repurchase transactions on the return of yields.

There is also a difference in who makes a profit on both transactions. Interest is paid to the lender of the security in securities lending. While in repurchase transactions, the benefit is pay to the buyer who is the one that provides the cash.

The main issue to distinguish them is the usefulness of each operation. Managers use both techniques of efficient portfolio management for two different purposes. Investment funds use investment in repos to be able to deal with situations of unexpected or massive redemptions. Therefore, to obtain extraordinary liquidity that allows them to meet their obligations to repay the investment. These operations will be contained in the KIID and their maturity will also be explained. Thus, repos are made as a financing operation for the investment fund. Also managers could use repos a seller to finance purchases of securities. So, after the fund buys a new security to invest then managers could sell it temporarily. The income generated by that sale is used to finance the money paid for its purchase. On the contrary, the securities lending are used to obtain extraordinary returns. These returns translate into incomes for the manager and a greater net asset value of the fund. Besides it is also use to reduce the fund costs.

Conclusions

Both securities lending and repurchase transactions represent ways for collective investment schemes to earn extraordinary income. However, it is not only the managers of these schemes who benefit, but also the participants. The securities lending technique allows for low management fees in ETFs. On the other hand, repos allow managers to obtain liquidity and made repayments. In addition, the two operations offer a high degree of transparency as they are included in the investment funds’ prospectuses. Thus, when an investor is looking for different possibilities of investment they should consider the use and conditions of these techniques.