Securities Lending Risk in ETFs

ETF providers often lend securities from their portfolios to short sellers and other borrowers, collecting fees that offset fund costs. This securities lending creates counterparty risk: if the borrower fails to return the securities or collapses before collateral can be liquidated, the ETF shareholder absorbs the loss. Collateral requirements and regulatory limits reduce but do not eliminate this risk.

Why ETF providers lend securities

ETF providers lend securities because the activity generates revenue. When a short seller wants to borrow 1,000 shares of Microsoft to sell short, they pay a borrow fee — typically 0.01% to 0.50% of the security’s value annually, depending on availability and demand. That fee is shared between the ETF provider and the fund shareholders.

A large ETF with $10 billion in assets might lend 5–10% of holdings at any given time, generating $500,000 to $1 million in annual lending revenue (if average borrow fees are 0.1% to 0.2%). The provider keeps 50–75% of that income, using the ETF’s share to reduce its expense ratio, effectively lowering the cost to shareholders while capturing profit.

This revenue source is appealing to providers, especially for low-cost index ETFs where the traditional management fee is microscopic — sometimes 0.01% to 0.05%. Securities lending can double the provider’s income on that fund.

The mechanics of the lending transaction

When an ETF lends securities, it does not hand over certificates; it transfers the economic ownership to the borrower. In exchange, the borrower posts collateral — usually cash equal to 100–110% of the securities’ market value, or sometimes U.S. Treasury securities held by the fund or a third-party custodian.

The borrower pays interest on the loan (the borrow fee), and the collateral earns some return — interest if it is in cash, or the yield if it is Treasuries. The ETF net return on lending is the borrow fee minus the cost of holding collateral, a spread that typically ranges from 0.01% to 0.30% of the loaned value annually.

Counterparty risk: the central concern

The risk emerges if the borrower faces financial distress or enters bankruptcy before the loan is settled. Suppose an ETF has loaned 10,000 shares of Apple (worth $1.5 million) to a prime broker, and the market value drops to $1 million due to a price decline. The borrower owes the original 10,000 shares back, but it has no economic incentive to return them if the collateral posted ($1.55 million) is worth more than the shares now are. If the borrower defaults and the collateral is insufficient to cover the loss, the ETF shareholders absorb the shortfall.

This risk is most acute during financial crises. In the 2008 financial crisis, several repo lending counterparties collapsed, and some securities-lending programs suffered losses. The 2023 failure of Silicon Valley Bank showed how rapidly a seemingly sound counterparty can deteriorate. ETF shareholders are exposed to these risks passively.

The indemnification clause—where the ETF provider or third-party custodian agrees to cover losses above collateral value—provides some protection, but it is only as good as the provider or custodian’s solvency. If the provider is also in financial distress, the indemnity may be worthless.

Collateral and its limitations

The collateral requirement—typically 100–110% of the loaned value—is the primary safeguard. A 100% requirement means if a security worth $100 is loaned, $100 in collateral is posted. A 110% requirement gives a 10% buffer.

However, the buffer’s adequacy depends on market volatility. If the underlying security drops 15% in value between pricing updates, and the collateral is only 110% of the original value, the collateral is now underwater. In fast-moving markets—especially during stress—collateral can fail to cover the loss.

The type of collateral also matters. Cash collateral is simple: it can be used immediately to purchase replacement securities. Collateral in Treasury bonds requires liquidation, which introduces timing and price risk. If Treasury markets are stressed or illiquid, converting collateral to cash and buying replacement securities at fair prices may be difficult.

Regulatory oversight and limits

Regulation places limits on securities lending to reduce systemic risk. In the U.S., SEC Rule 17f-4 requires that securities lending be limited so that revenue does not exceed the fund’s operating expenses (management fees and other costs). For many index ETFs with very low expense ratios (0.03%), this cap is reached quickly, limiting the amount the provider can lend.

The rule also requires that the fund hold collateral in cash or Treasury securities, not equities (which would concentrate risk). The collateral must be marked to market daily, and if it falls below the threshold, new collateral must be posted immediately.

These rules reduce but do not eliminate risk. A collateral framework can fail if assets are concentrated among a few large borrowers or if the borrower base includes firms that are correlated in distress (e.g., all prime brokers, all hedge funds).

Transparency and disclosure

ETF funds must disclose their securities-lending activities in their annual reports. They typically report the total value of securities lent, the revenue earned, and the allocation of that revenue. However, detailed counterparty information—the identity of borrowers and the collateral arrangements—is often not public, citing confidentiality.

This opacity makes it difficult for investors to assess the true counterparty risk. If the ETF’s lending counterparties are concentrated among a few systemically important firms, the risk is higher than if lending is dispersed. Investors cannot easily evaluate this without more granular disclosure.

When securities lending becomes material

For a large, passively managed index ETF with a 0.03% expense ratio, securities lending might contribute an additional 0.005% to 0.01% annually to investor returns. Over a portfolio of $10 billion, this translates to $500,000 to $1 million per year—meaningful, but not transformative.

For smaller or niche ETFs with higher expense ratios, or for funds that aggressively pursue lending revenue, the contribution can be larger. Some specialized strategies intentionally use securities lending to subsidize costs. These funds carry higher counterparty risk exposure because more securities are lent.

Investors who believe counterparty risk is unacceptable can choose ETFs that do not lend securities. Some funds are explicitly set up as “non-lending” products, forgoing this revenue source to avoid the risk entirely. These funds typically have slightly higher expense ratios to compensate.

Interconnection with systemic risk

Securities lending contributes to interconnectedness in the financial system. Banks, prime brokers, and hedge funds are all tied together through lending arrangements, collateral chains, and repo markets. When one firm fails, the shock propagates through lending counterparties, potentially creating wider stress.

A 2023 report on financial stability noted that securities lending practices had become more concentrated among a smaller number of large providers, increasing systemic risk. ETF shareholders have a small, indirect exposure to this concentration: if a major lender-counterparty fails during a crisis, ETF lending portfolios may incur losses alongside broader market stress.

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