“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. 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 provided against derivatives currently treat GBIL no differently than an ETF containing Russell 2000 stocks. When traders provide $100 of collateral, the regulators guide the receivers of that collateral about 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.
Jason Bloom, head of fixed income and alternative product strategies at Invesco, explains that recent periods of volatility for fixed-income ETFs, including a liquidity stress scenario in March and April 2020, have proven that in many cases fixed income ETFs can offer liquidity superior to the underlying bonds themselves.
This validation of the ETF technology through those periods when markets have been most challenged is opening doors for further use cases for the ETF structure, he says.
Goldman is separately working with regulators 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, they may be a question of prioritization. For an asset manager, they 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.
Traditional approaches of tracking ETF trading volumes are typically problematic because ETFs tend to trade across multiple exchanges at once and have significant off-exchange activity. This results in understated liquidity for ETFs and overly restrictive concentration limits for those collateral providers that want to use ETFs as collateral.
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. In addition, Bloomberg Terminal users can access fund flow data and metrics that provide average aggregate trading volumes in ETFs globally across multiple trading venues. BNY Mellon plans to use these aggregate trading volumes as part of its collateral management service in the near future.
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 there was 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 provides 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.
In 2018, BNP Paribas Securities Services, a unit of BNP Paribas Group, was an early mover in starting to accept ETFs as collateral against securities lending arrangements in which it acts as the principal lender. Yannick Bierre, head of principal lending, says the firm is now authorized to accept a predetermined list of ETFs—primarily ones it can reuse as collateral itself—from a handful of issuers, but the list may evolve over time. “The ETF market is growing, so we are changing our approach to the product,” he says.
Also in 2018, Citigroup added ETFs to its list of acceptable collateral against agency securities lending transactions, in which 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. Agreeing with trading counterparties to add ETFs to their collateral schedules will take some time. Once agreed in principle, the process of executing the collateral schedule amendments is made easier with a new BNY Mellon tool called RULE ™, which enables clients to agree changes to their existing collateral schedules to include ETFs.
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 U.S. regulators indicated that they do not consider the liquidity characteristics of ETFs and their underlying components as identical.