“If you’re a global macro hedge fund, and you don’t have fixed-income expertise, you don’t necessarily want to spend time on this,” says Steve Sachs, head of capital markets at Goldman Sachs Asset Management, which created one of the Treasury bill ETF products. “It’s operational and not an alpha-generation exercise.”
The genesis of Goldman’s idea was to deliver a money market fund experience in an ETF format, says Sachs. The Goldman fund, called “GBIL,” launched in 2016, invests in Treasuries out to one year in duration, and now holds more than $3 billion in assets. Users of GBIL are mostly registered investment advisors today. But Sachs says, “We do have a number of [institutional] clients that are using it for collateral purposes--the collateral usage aspect of GBIL was absolutely contemplated from day one.”
One current sticking point is that regulators determining what collateral can be pledged against derivatives currently treat GBIL no differently than an ETF containing Russell 2,000 stocks. When traders pledge $100 of collateral, the regulators guide the receivers of that collateral how to discount its value in case one side goes belly up. With the typical equity-like haircut for ETF collateral, the requirement today can be north of 15%.
Invesco Ltd, which runs a Treasury collateral ETF with the ticker symbol “CLTL”, received a waiver from the Securities and Exchange Commission in March 2018 to apply a 2% haircut for collateral posting. Next the firm is waiting on a decision from the Commodity Futures Trading Commission, which currently does not allow any ETFs to be used for collateral on cleared derivatives.
Tim Urbanowicz, director in fixed-income ETF strategy, said if the CFTC gives the green light for Invesco and its CLTL fund to be posted as eligible collateral on cleared derivatives it “opens up a whole new world of possibilities for the product.”
Goldman is in separate discussions with the CFTC to allow GBIL to be posted as collateral in cleared trades as well as exchange-traded derivatives, and to lower the haircut to 2% or less from its current 15-50% range.
For all these developments, the constraints to broader adoption of ETF collateral are not small. For securities dealers, it may be a question of prioritization. For an asset manager, it may be the risk management of ETFs or convincing a board of directors.
On top of that, very few ETFs are alike. Even the same ETF can trade on a dozen different exchanges. In the U.S., trading volumes have been easy to come by but in Europe, under Mifid II, there was no requirement to post trading volumes for ETFs until January 2018, so volumes were scarce.
Bloomberg LP has an analytics tool called Port that allows investors to drill down into an ETF’s characteristics, based on the fund’s underlying portfolio. This July, the company also launched new metrics that aggregate the trading volumes in all ETFs globally across multiple trading venues.
ETF proponents believe that industry practitioners should be looking at the liquidity of the components anyway, not how often the fund trades.
“The key collateral quality metric should be underlying liquidity and the collateral receivers’ ability to liquidate through a liquidation agent,” says Jean-Christophe Mas, head of ETF trading at BNY Mellon Capital Markets LLC, which is a broker dealer affiliate of the bank and authorized participant or “AP” for such funds.
Not all firms that receive ETFs as collateral have appointed an AP to help them liquidate those holdings in a turbulent market, so they may not be able to price the ETFs themselves or have the ability to create or redeem shares. If more firms were familiar with the redemption process, perhaps the fuller benefits of ETF collateral could be realized, Mas points out.
ABN AMRO Clearing brought its collateral activity to BNY Mellon’s triparty systems after going live on the platform in 2018. Valerie Rossi, global head of securities finance of ABN AMRO Clearing based in Hong Kong, says she has noticed more widespread industry adoption of ETF collateral than four to five years ago, especially for ETFs that replicate main indices. But she said there is still a reluctance on the part of some participants. “If the average traded volume of that ETF is significantly lower than its components, then firms may exercise caution and limit exposure to those instruments,” says Rossi. For any “synthetic,” leveraged or inverse ETFs she says, “The conversation becomes a lot more restrictive.”
ABN AMRO Clearing primarily pledges ETFs and other forms of collateral to receive high quality assets such as government bonds in an arrangement known as a “collateral transformation” trade designed to optimize its balance sheet.
BNP Paribas Securities Services, a unit of BNP Paribas Group, last year started accepting ETFs as collateral against securities lending arrangements where it acts as the principal lender. Yannick Bierre, head of principal lending, says the firm is now authorized to accept a finite list of ETFs from a handful of issuers -- primarily ones it can re-use as collateral itself -- but the list may evolve over time. “The ETF market is growing, so we are changing our approach on the product,” he says.
Citigroup last year also added ETFs to its list of acceptable collateral against agency securities lending transactions, where the bank acts as an intermediary between a borrower and lender.
On the Radar
The rise in ETF Collateral is on the minds of sophisticated players in the securities lending and collateral markets. But convincing hundreds of clients to add ETFs to their collateral schedules will take time. The process of adding them could be made easier with a new BNY Mellon tool called RULE ™, which can help clients with changes to their existing collateral schedules to include ETFs. A separate Continuous Portfolio Optimizer tool can also work out the optimal places for the client to deploy that collateral.
Educating participants about the uses and behaviors of ETFs is one near-term focus, closely followed by getting regulatory attention on ETFs in the context of high-quality liquid assets, proponents say. Some commenters in the months leading up to the U.S. iteration of the Basel III Liquidity Coverage Ratio final rule argued that ETFs tracking indices of HQLA assets should be classified as HQLA. However the final rule does not include ETFs as US regulators indicated that they do not consider the liquidity characteristics of ETFs and their underlying components as identical.