Securities Lending Exposed: Your ETF at Risk
Securities lending is one of the hidden secrets of Wall Street. Yet it gets very little attention, other than the general statement, "Don't worry. It will be fine."
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Summary
Securities lending is one of the hidden secrets of Wall Street. Almost everyone seems to be doing it. Many brokers do it with client securities to generate extra income. Many ETFs do it with investor-owned assets to generate extra income. Yet it gets very little attention, other than the general statement, "Don't worry. It will be fine."
Securities lending is a big money-making machine for Wall Street. And if done properly, the risk should be minimal.
The problem, however, is that it does not seem to be done properly. In 2023, several major banks, including Goldman Sachs, JPMorgan Chase, Morgan Stanley, and UBS, along with EquiLend, agreed to pay $499 million to settle an antitrust lawsuit related to the securities lending market.
In addition, many ETFs appear to be issued under legal exemptions that water down the otherwise strict securities lending requirements required under the Investment Company Act of 1940. This means that in another crisis like 2007, a big chunk of the assets in your ETF could be gone.
And in normal economic times, or when America was the only hyperpower with unlimited resources to bail out failing institutions (like during the 2007 financial crisis), securities lending might be a risk that investors could ignore. But not anymore.
America's Achilles Heel: How Debt and Financial Instability Threaten Your Investments
The era of American global rule is coming to an end. It is happening faster than many realize. We're not just facing a potential threat. We are witnessing the decline in real time. China, India, Russia, and others are rising rapidly.
This is not a future possibility. It is our present reality. The world is moving toward a multipolar order, and America's dominance in global affairs is coming to an end.
This isn't about taking sides. It's about recognizing reality. Much like checking the weather forecast before planning a day out, you may hope for sunshine, but if all the signs point to rain, it would be unwise to ignore the facts.
Meanwhile, we face serious challenges at home. Our financial system is showing cracks, with recent bank failures exposing underlying vulnerabilities. These failures aren't one-off events but rather signs of deeper, systemic problems in our economy.
To make matters worse, the U.S. government is carrying a staggering amount of debt. More than at any time in our history. With such a heavy debt load, the government's ability to respond effectively is now severely limited.
In this new world order, understanding the fine print of our investments is essential. The ETF regulations take on new importance as traditional safeguards are eroding, such as the ability of the US government to bail out failing institutions.
I am not talking about certainties, but probabilities. I still believe that the US government, in a 2007-like scenario, will do everything it can to ensure the integrity of the US financial system. But what was once unthinkable (a US government unable to help) is now possible. Certainly a low probability risk, but not a zero risk anymore. And even if the US government were to intervene, it may favor an approach similar to the new FDIC bail-in provisions (outside the scope of this article) where the ETF funds are guaranteed but not accessible for a long time.
For those extreme scenarios, it is better to own an ETF that operates under strict securities lending rules. Not every ETF does. This distinction could mean the difference between preserving your wealth and losing it all.
ETFs Uncovered: Why the Difference Between Registered and Non-Registered Matters
Securities lending happens when ETFs temporarily lend the assets of the ETF to other investors in exchange for a fee. This practice generates additional revenue for the ETF fund. However, it also introduces risk if the borrower defaults and fails to return the borrowed security.
Imagine you have a $1 million portfolio of Treasury bonds. You lend 50% of it to another investor for a few months (securities lending) to generate some extra income. But now the other investor (the borrower) defaults and doesn't return your Treasury bonds.
Well, hopefully you had received collateral from the borrower, and hopefully the collateral is valuable enough to replace the value and income of the securities you lent. If not, the value of your portfolio just took a large hit. That is the risk of securities lending in a nutshell.
ETFs, including those of well-known issuers, come in two flavors: registered and unregistered. This distinction is important in the context of securities lending. As you may have guessed, registered ETFs are safer than unregistered ETFs as described below.
Registered ETFs
Registered ETFs are ETFs that are regulated under the Investment Company Act of 1940. They must adhere to strict rules regarding securities lending. They are required to obtain a minimum of 100% collateral for any securities that are loaned out. The collateral must be liquid and readily available.
Additionally, registered ETFs cannot have more than one-third of their total assets lent out at any given time to maintain adequate liquidity. Registered ETFs must also do a daily mark-to-market. As the value of the security increases, the borrower must post more collateral.
They also need to provide detailed disclosure in their prospectuses, financial statements, and SEC filings. These stringent rules are designed to protect investors by limiting risk and ensuring transparency, which is especially important in today's high-risk environment.
Non-Registered ETFs
Non-registered ETFs follow a less rigorous process. They are typically issued under Section 6(c) (this section allows ETFs to operate without complying with certain provisions of the 1940 Act) or Rule 6c-11 (this specific SEC rule, adopted in 2019, provides a streamlined process for ETFs to operate without the need for individual exemptive orders).
They are not subject to the one-third lending cap. There are no clear legal requirements specifically for collateral in ETF securities lending.
These ETFs may also not be required to provide the same level of detailed reporting as registered ETFs. While this flexibility can lead to potentially higher returns, it also introduces additional risks, which can be a double-edged sword in a fragile economic environment.
You would think that most ETFs traded in the US would be registered ETFs. Unfortunately, this is not the case. Securities lending is a very important source of revenue for fund managers to supplement the fees they charge investors and increase their profits. In normal times, this may not be a problem. But if we have another financial crisis like the one in 2007, where financial institutions fail (like Lehman Brothers did back then), this more "flexible" approach to securities lending could be disastrous for your investments.
How to check if your ETF is registered under the Investment Company Act of 1940
To determine if your ETF is registered, you can follow these steps:
Visit the SEC's EDGAR database: The U.S. Securities and Exchange Commission (SEC) maintains the EDGAR database, which is a great resource for accessing public filings by companies, including ETFs. Use the search function to enter the name or ticker symbol of the ETF. This will take you to a list of filings related to that ETF. Look for documents such as the prospectus, registration statements (Form N-1A for mutual funds and ETFs), and annual reports (Form N-CSR). These documents provide information about the ETF's registration status and structure.
Review the prospectus: The prospectus is a key document that outlines the ETF's investment objectives, strategies, risks, and fees. It also indicates whether the ETF is registered under the Investment Company Act of 1940.
Visit the fund manager's website: Most ETF providers maintain a dedicated website for each of their funds. Here you can find detailed information about the ETF, including its registration status, investment strategy, performance data, and other important disclosures. Look for sections such as "About Us," "Fund Information," or "Regulatory Filings.
Conclusion
By following these steps, you can determine whether your ETF is registered, which is essential to making informed investment decisions. This may seem like overkill. Nobody wants a major economic disaster. However, if such an event were to occur, you will be glad you took the time to do this research, as it could mean the difference between losing your money and keeping it.
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