A greater level of transparency is needed when ETF providers lend out securities held within their funds, according to industry experts.
The extent of securities lending activity varies across ETFs and issuers, differing in the amount of securities on loan, and the level and type of collateral held in place.
Whitechurch senior analyst Ben Seager-Scott says: "It worries me that you don't know what you're holding in securities lending."
For example, iShares can lend out up to 95% of the securities held within their physical ETFs, although on average, only 10-15% of portfolios are lent out at any one time.
However, the iShares FTSE 250 ETF lends out 80% of its underlying securities on average and the maximum it has lent out is 95%, in the year ending Q2 2010, according to BlackRock.
The iShares Barclays Capital Euro Inflation Linked Bond has an average of 55% on loan and has lent out a maximum of 87% in the same time period. This is followed by the iShares MSCI Japan Small Cap fund, which on average lent out 45% and has lent out a maximum of 86%.
Seager-Scott adds: "It gives me cause for concern, because if I'm a government bonds ETF trader and the market goes wrong, and I don't know what my fund is backed by, then that is worrying."
Speaking at a recent London Stock Exchange conference, iShares director of EMEA product development Martin Bednall said: "We are looking internally as to how to improve transparency on securities lending."
BlackRock vice president Stefan Kaiser says: "We do securities lending but it's important to understand the process - there is independent oversight provided by BlackRock's Risk and Quantitative Analysis Group (RQA).
"What we do in securities lending for our Dublin domiciled iShares is governed by the Ucits guidelines but also the counterparties, counterparty limits and levels of over-collateralisation are reviewed on a daily basis by this independent BlackRock group"
The Dublin domiciled iShares range over-collateralises its securities lending activity, by between 102.5% and 112%.
The International Securities Lending Association chief executive Kevin McNulty says: "Most lenders do require over-collateralisation and that would be the case behind ETF lenders as well.
"The actual strict requirements for collateralization vary from one lender to another, but it's certainly commonplace. It's one way for lenders to substantially reduce credit risk."
The level of collateralization depends on the type of collateral used. For example, if iShares lends out equities, the level of equity collateral posted is between 110%-112%, or if government bonds or certificates of deposit are used as collateral, this level would be 108%.
Kaiser says: "We only accept 40% of the average daily traded volume of equity collateral that we accept; that's another important differentiator- if there was ever a borrower default we want to make sure we can liquidate the securities that we've taken as collateral and buy back those securities rapidly."
In terms of how long it takes to liquidate collateral, should a borrower default, Kaiser says: "It's usually very quick; in a recent default we did that within one day. "
The amount of revenue generated from the lending activity that is put back into the ETF also varies among providers.
iShares puts 50% of the gross revenue back into the Dublin-domiciled funds, with BlackRock covering operational costs. This allows the ETFs to offset some of the costs associated with holding physical securities, such as tracking error.
In terms of swap-based funds, Deutsche Bank says its db x-trackers ETFs do not engage in securities lending, in terms of the assets backing the funds.
However, head of db x-trackers UK Manooj Mistry says the firm's ETFs do benefit from securities lending revenues, arising from hedging activities undertaken by Deutsche Bank as swap counterparty.
In order to deliver the index performance under the swap, Deutsche typically hedges its exposure by buying and holding on its books the components of the index being tracked.
With this inventory, the bank can generate revenues by lending out the stocks. Mistry says the benefit of this type of lending is that it does not expose the fund to any securities lending risk, as it is completely at Deutsche's risk.
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