No one expected them to go that far. Sure, most ETF industry watchers expected the European Securities and Markets Association (ESMA) to crack down on transparency around securities lending. But none thought ESMA would go as far as ruling that all securities lending revenue has to be pumped right back into the fund for the benefit of investors. Which is exactly what happened last week as ESMA announced its new ETF guidelines.
Although the guidelines cover Europe only, they could prove a game changer for the ETF industry, where providers argue revenues from securities lending keep costs low for investors. Just how much ETF providers make from securities lending activities is hard to quantify though – according to the Financial Times, participants are notably wary about sharing information about their securities lending activities.
But according to a response issued by the EDHEC-Risk Institute this morning,
“This new rule clearly changes the situation and the business model of ETF providers who have chosen physical replication because securities lending represented considerable sources of revenue for the asset management firms.”
The potential for a huge, negative impact has prompted credit rating agency, Moody’s to call ESMA’s guidelines “credit negative” for asset managers, including some ETF providers like BlackRock and State Street for whom profitablilt could be hurt by higher compliance costs in general and, specifically, the ban on securities lending. Said Moody’s:
“The guidelines are credit negative for asset managers that sponsor ETFs in Europe…securities lending provides ETF sponsors extra revenue to compensate for slim ETF management fees….”
While some ETF sponsors do return 100% of securities lending fee income to fund investors, others retain a percentage for themselves.
The payoff? Increased investor confidence in ETFs will lead more investors to use them said Moody’s. And improved investor confidence could be a boon to the industry.
My take? Better guidelines around securities lending activities could make ETFs a substantially more compelling proposition for institutional investors like plan sponsors, who are clamping down on counter party risk in a big way. But whether or not costs to retail investors rises in tandem remains to be seen…And, of course, ESMA’s recommendations only cover Europe so it’s definitely worth watching whether or not Canadian and US regulators go the same route.