There is no doubting the increasing popularity of exchange-traded funds (ETFs).

According to a report released in October by Barclays Global Investors (BGI), global ETF assets reached a record high of USD 891 billion at the end of August 2009 – 3.9% above the previous high set in July 2009, and 10.6% above the figure for April 2008, which was a record at the time.

Companies like Deutsche Bank, meanwhile, now provide more than 100 ETFs which can track a large variety of asset classes, from equities to commodities, currencies to hedge funds. The bank announced in April that db x-trackers, its ETF platform, passed EUR 20 billion in assets under management.

This growth in popularity has meant that more and more traders have ETFs on their books, which has led to growing numbers of securities borrowers offering the instruments as collateral.

This is part of a wider trend, of course – many borrowers in the industry report that they are seeking to diversify the collateral they receive and move away from cash collateral, given its perceived poor performance during the credit crunch.

For instance, at the latest meeting of the Bank of England’s Securities Lending and Repo Committee in September, Joyce Martindale from the National Association of Pension Funds commented that larger securities lenders were looking at segregated collateral pools and revising the collateral they would accept.

Stefan Kaiser, a business strategist at BGI’s securities lending team, has also seen this trend develop. He explains that over the past two years his colleagues have increasingly looked at the possibility of using ETFs as collateral, in addition to more traditional forms such as cash, equities and government debt. Kaiser works closely with iShares, Barclays’ ETF provider, and says that the use of ETFs as collateral has created even more opportunities to work closely together.

However, this increase in use is not just down to BGI trying to encourage the use of ETFs in the industry as a whole, Kaiser explains. “It’s also because the brokers that are borrowing from us are increasingly active in iShares so they have a lot of ETFs that they want to finance, meaning they want to pledge them as collateral. A lot of the time they approach us and say they would like to pledge these securities as collateral.”

Clearly, the securities lending industry is beginning to take notice of ETFs and their possibilities. In August this year, 4sight Financial Software announced that it was extending its 4sight Securities Finance (4SF) software solution to include support for the borrowing and lending of ETFs. Jason Hayes, the firm’s North American sales director, said at the time that the move had been taken to reflect the fact that ETFs are becoming “a more prominent feature of the securities lending landscape”.

In addition, a number of conferences this year, including the International Securities Lending Association’s workshop at the end of September, have discussed the issues involved with using ETFs as collateral. These developments came after other events in 2008 that indicated a positive future for ETFs in securities lending, including ICAP, the interdealer broker, announcing that it was expanding its i-Sec electronic securities lending platform to include provisions for ETFs and exchange-traded commodities.

So what are the advantages of using ETFs as collateral? From the borrower perspective, any possible new form of collateral is likely to be seen as welcome, as it will provide extra flexibility. Even those borrowers who are less active in the ETF field are often likely to be trading ETFs or will have exposure to them at some point.

For lenders, however, the advantages are more precise. In standard equities-as-collateral practice, lenders provide a security that is part of one index and take in a security that is part of another. “Liquidity, volatility and correlation” between these two indices is vital to this process, Kaiser explains, but the correlation between the two securities may not be as strong as the correlation between the indices.

“But if you take ETFs as collateral the advantage that you have is that, at least on the collateral side, you get that index exposure that the ETF represents, so from a modelling and risk perspective they are actually superior,” he says.

Additionally, ETFs offer an inherent diversification, providing reassurance for those investors who were stung by the credit crunch. “Just because you have a perfect slice of that index already, you’re better off than having just one security as collateral,” Kaiser adds.

The liquidity argument also has a geographical element. Lenders holding collateral made up of – for instance – Chinese shares would be unable to liquidate them during late London trading, as the Chinese market would be closed for the night.

However, collateral could be made up of ETFs tracking a Chinese index but listed on a UK-based index – allowing the shares to be liquidated during working hours.

But the world of ETF collateral is not as simple as whether or not lenders accept them and borrowers can offer them.

GSL’s Amsterdam Summit on 8th October saw a large period of discussion on the various types of cash collateral reinvestment and the pros and cons of each, and the ETF sphere is similarly complex.

Broadly speaking, there are two main types of ETFs: the in-specie (or in-kind) model and the swap-based model. The in-specie structure sees investors hold a basket of securities from the index that they seek to track, resulting in returns similar to the index in general.

The swap-based model on the other hand also requires a basket of securities, but these do not necessarily have anything to do with the index being tracked.

Instead, the fund enters an index swap agreement with a counterparty which ensures the performance of the underlying fund to the ETF.

Currently, BGI only takes in-specie ETFs as collateral, Kaiser says. This again comes down to the issue of transparency. Various studies suggest that swap-based ETFs more accurately track indices, but Kaiser believes that their structure impacts their ability to be used as collateral.

“With physically-replicating ETFs we know exactly what its structure is. Other kinds of ETFs are much harder to know what is really there once you want to liquidate it,” he says.

Additionally, swap-based ETFs introduce counterparty risk, as holders have exposure to the bank which writes the swap, although UCITS rules limit this exposure to 10% of the fund’s net asset value.

Despite these advantages, ETFs currently take up a very small percentage of total collateral in the securities lending market. While this may change as the popularity of ETFs in general increases, other changes may be needed to boost the market – including regulatory ones.

“There are some regulatory hurdles to the growth of ETFs as collateral,” says Kaiser. “ETFs cannot be pledged as collateral in jurisdictions, for instance in Ireland.” This is because of the way the UCITS rules are interpreted in different countries – in the UK, regulators view ETFs as equities, allowing them to be used as collateral, while other countries consider ETFs to be funds.

However, there are more practical obstacles to the increased use of ETFs, according to Kaiser. In normal circumstances, borrowers are able to say they will take securities from an index, for example the FTSE 100. But in the case of ETFs, this is not possible – instead, each ETF offered as collateral must be observed on a “case by case basis”, which is obviously far more time consuming than accepting standard equities.

There are also difficulties in understanding the trading volumes of ETFs, Kaiser adds, which can impact on their liquidity. “The trading volume that you see on exchange is not always a good measure for the true liquidity of trading that ETF,” he says.

“For example, if you have a FTSE 100 ETF, and there’s only a few million pounds of trading during a particular day, that doesn’t mean that’s all trading that you could do. Looking at how much was traded of an ETF is not a good estimate of what you could trade.”

The use of ETFs as collateral seems set to grow in popularity as the instruments themselves become increasingly accepted by the financial world – something that the Barclays report and similar studies over the past year have indicated is already happening.

There are obstacles in the way, whether they are a reluctance among investors to alter strategies, regulatory constraints or a prevailing “wait and see” approach.

However, the fact that borrowers are always looking for extra flexibility could be the clinching factor, at least when it comes to the first point – a reluctance to change – especially given the current move to new strategies and away from practices that stung lenders during the credit crunch.

“A lot of the changes in the securities lending industry are borrower-driven,” says Kaiser. “If borrowers need to finance certain securities then they’ll ask the lender to take those as collateral. If the lender sees an opportunity for their clients to get additional lending balances, they will do that.”