European fund managers will have to return all profits made from securities lending transactions to their investors according to new rules announced on Wednesday by the European Securities Markets Authority (Esma).
Securities lending – where shares or other assets held in a portfolio are lent, typically to a hedge fund or other short-seller, in return for a fee – is common practice across the fund management industry.
Fund managers argue that securities lending improves returns and reduces costs for investors. Estimates for how much revenue is generated by securities lending in Europe are rare as market participants are notoriously secretive about this part of their business. However, the new rules are likely to cost millions in lost revenues to passive fund managers who are big players in the securities lending industry.
Kevin McNulty, chief executive of the International Securities Lending Association, said that ISLA supported the disclosure of revenues and fees generated by securities lending transactions.
Mr McNulty said that Esma’s new rules could act as a deterrent to some managers engaging in securities lending if they were deemed to preclude the manager from charging a commercial fee for doing so.
The new rules present a particular challenge to the business model of BlackRock, the world’s largest fund manager, which earns significant revenues from securities lending transactions undertaken by its iShares exchange traded funds operations in Europe.
BlackRock currently retains 40 per cent of the revenue generated by stock lending (net of fees) while 60 per cent is returned to the fund to reduce charges.
BlackRock has argued that tighter rules on securities lending would place it at a competitive disadvantage to synthetic ETF providers who are unlikely to be affected by the new regulations. This is because the parent investment bank, and not the synthetic ETF provider, carries out any securities lending transactions.
Esma announced the stricter rules on securities lending as part of new guidelines for Europe’s exchange traded funds industry following a 15-month consultation process with ETF providers and market participants.
Steven Maijoor, chairman of Esma, said the new guidelines were “an important step in the development of the regulatory framework of Ucits”.
“These comprehensive guidelines are aimed at strengthening investor protection and harmonising regulatory practices across this important EU fund sector,” said Mr Maijoor.
But Esma has stopped short of applying specific restrictions to derivative-linked “synthetic” ETFs. It will not require synthetic ETFs to carry a specific identifier to distinguish them from “physical” ETFs which buy the constituents of the index they are designed to track.
Esma has also decided against categorising any ETFs as “complex” products, which would have prevented them from being sold on an execution-only basis. The decision as to whether products such as leveraged or inverse ETFs should be classified as complex is to be determined as part of the current Mifid review, which will examine all financial products sold to retail investors.
Esma has backed away from requiring ETF providers to allow direct redemptions by investors, a proposal that the regulator had tabled during the consultation process. However, the regulator has specified that Ucits ETFs will have to ensure appropriate redemption conditions for secondary market investors by opening the fund for direct redemptions when liquidity in the secondary market is not satisfactory.
The new rules are not expected to come into force until the end of February 2013 because Esma has started a further consultation process on the treatment of repo and reverse repo arrangements which will run until September 25. It aims to integrate any new guidelines on repo and reverse repo with the guidelines on securities lending and ETFs into a single package of rules.
The final report of Kay review of UK equity markets, published on Monday, also recommended that all income from stock lending should be disclosed and rebated to investors.
Esma’s decision to require all revenues from securities lending (net of operating costs) to investors was welcomed by John Kay.
“This is a step in the right direction”, said Mr Kay.
The Kay review argued that the risks associated with stock lending were borne by the investor so there was a divergence between the recipient of the income (the fund manager and the investor) and the bearer of the risk (the investor alone). This divergence, said the Kay review, could provide an inappropriate incentive to engage in stock lending and, more broadly, was inconsistent with fiduciary principles.