Developing a viable create-to-lend market for European exchange-traded funds will be crucial in boosting ETF trading volumes, said panellists at Markit’s Securities Finance Forum in London on Tuesday.
Create-to-lend is a process by which market intermediaries create ETF units to allow other traders to cover short positions.
“Because an ETF is an open-ended fund, you can create as many units as you want,” Michael John Lytle, chief development officer at Source, an ETF issuer, told attendees at yesterday’s forum.
“If you’re short and you want to cover your position, you know you can go to someone who has access to the fund, have them create units and give them to you,” Lytle explained.
“The economics of doing this should be equivalent to doing the transaction in the underlying basket of securities tracked by the ETF,” Lytle said. “If the cost of borrowing the basket is, say, 30-40 basis points, it should cost a similar amount to borrow the ETF.”
But inefficiencies in the European share market’s infrastructure and the fact that many European ETF owners do not lend their holdings mean that it can often cost much more to borrow an ETF than it should, the panellists at Markit’s event conceded.
“There’s a massive disjoint,” said Andrew Jamieson, a managing director in iShares’ capital markets team.
“There’s $400 billion of European ETF inventory already sitting in people’s custody accounts and an almost infinite ability to create more units,” said Jamieson.
“If there’s such a large potential supply, why does it often cost 250 basis points to borrow a European ETF?” Jamieson queried. “If it costs 30-40 basis points to borrow a basket of European stocks, such as the DAX or CAC 40 index, then that’s what it should cost to borrow an ETF tracking those indices.”
Getting the lending market going will be crucial in allowing European ETF trading volumes to approach the substantially higher levels of the US market, said Source’s Lytle.
“The US ETF market turns over $50 to $130 billion a day,” said Lytle, “while Europe turns over $3 billion on exchange. That makes daily exchange turnover 1 percent of ETF assets in Europe, but 5-10 percent in the US.”
“In the US market ETFs can have substantially more liquidity than some of the underlying stocks, but in Europe we see the reverse,” Lytle said.
According to Lytle, the most liquid stock on the London stock exchange is currently BHP Billiton, which has four times the average daily turnover of the iShares FTSE 100 ETF (LSE: ISF), the most liquid London-listed ETF. But in the US the most liquid stock, Apple, has only around three fifths the average daily turnover of SPY, the SPDR S&P 500 ETF, on the New York exchange.
The structural impediments to greater on-exchange turnover in European ETFs include multiple listings of the same funds on different European exchanges, a lack of connectivity between the region’s clearing and settlement systems and differences in tax treatment in different European countries.
But encouraging a more active short selling market in Europe is critical in ensuring higher future trading levels, argued Lytle.
“The ability to go long and short is crucial for trading activity,” he said. “If you only have investors holding long positions, with a limited amount of shorting, bid-offer spreads will be wider than they otherwise would be.”
In the meantime, however, Europe-wide financial transaction taxes (FTT) threaten to depress trading volumes further, panellists conceded.
“FTT is a massive issue for the trading and lending markets and the ETF market will see knock-on effects,” said Source’s Lytle. “If we get an FTT that looks like France’s, with exemptions for market makers and for stock lending, then it’s not such a big issue.”
“But if we see an FTT that looks like the Greek proposal, with a tax on every leg of a transaction, we’re talking about a multiplier effect that could drive bid-offer spreads substantially wider, and the end-investor will be hurt,” said Lytle.