Exchange-traded funds are an important part of the discussions over the broadening role of secured finance in the post-crisis world. In this article, we explore how ETFs interact with the world of securities finance and collateral.
The Role Of Collateral
These days, much of the debate surrounding exchange-traded funds inevitably comes down to the subject of collateral. There are many different angles surrounding the topic but, on a larger scale, collateral is at the heart of fundamental change across the financial markets. Regulatory initiatives, including Dodd-Frank in the US and the European Market Infrastructure Regulation (“EMIR”), require centralised clearing of over-the-counter (“OTC”) derivatives; and in light of ongoing concerns over counterparty exposures, firms increasingly require collateralisation for bilateral trades. This increasing demand for collateral comes at a time when proprietary trading is being heavily discouraged by regulators, thus decreasing firm inventory; and when the pool of the highest quality government bonds has declined dramatically due to credit rating downgrades.
The structural changes at both buy-side and sell-side firms have been substantial and, given that we are in the midst of concurrent sweeping changes, there is no proven model to follow. This presents a major challenge for the market as a whole. Transparency is another watchword being bandied about as a solution to the many problems highlighted during the financial crisis. Often seen as a panacea, transparency also applies to ETFs and collateral.
First, let’s examine the purpose of collateral. Simply put, for most financial transactions, collateral acts as a safety net that protects the position of the entity that carries the exposure. Should its counterparty fail to meet its obligations, generally the non-failing entity uses the collateral to re-establish its original position. Both sides of the transaction—the original position and the collateral held—are typically marked to market on a frequency determined either by market standard, contractually between counterparties or as an obligation for centrally-cleared transactions.
Often debated, one measure of the quality of collateral is how quickly and easily it can be transformed from its existing condition into the original position. In other words, can it easily be sold or disposed of and the original position re-established through acquisition or other means? In our opinion, there is a further test to consider—when the collateral is disposed of, how closely do the proceeds match the value ascribed to it at the last mark-to-market calculation? This final assessment takes into account variations in valuation that may have different results, depending on asset liquidity, prevailing market conditions or other factors.
It is important to note that in the securities markets, firms seldom accept collateral with the objective of becoming the owner of the asset in a default situation—the objective is to sell the collateral. There is no requirement for the holder of collateral to sell the asset if a default occurs, but this is the usual practice. For this reason highly-rated, but illiquid assets should generally be assumed to be of lower quality than other assets that are more easily sold. An example of this can be seen in the comparison of a corporation that has issued common stock and corporate bonds. A corporate bond with a high rating can be considered high-quality, as it is a security offering the regular payment of interest and the return of the principal at maturity. Yet trading in the corporate bond market takes place OTC and the general illiquidity of the market is widely acknowledged. The rating of the bond has nothing to do with the ability of a collateral holder to sell it at a time of crisis. By contrast, the common stock of the same company will have an exchange-quoted price, with data readily available on historical price fluctuations and traded volumes. Further, this data can be back-tested through times of crisis to assess how predictable a given valuation would be in a stressed environment. It may be that the common stock is a more useful form of collateral in terms of executing sales at predictable prices and quantities.
It is, of course, possible for the collateral holder to elect to keep the collateral until market conditions change and a more favourable execution price can be obtained or a bond matures, but this approach represents the objectives of a minority of collateral takers.
It’s worth making one final point before we turn to the subject of ETFs and collateral in detail. The collateral takers referred to in this article include a broad range of market participants. The spectrum of lenders includes the ETFs themselves, securities lenders, cash lenders, and we argue that this group should be extended to include depositories, central banks, central counterparties and other organisations that require collateral from market participants.