Two firms are seeking clarification from Malaysia’s securities regulator over fee-sharing arrangements for lending out stocks underlying exchange-traded funds.

It is hoped that the Securities Commission will provide confirmation on the issue, enabling the practice finally to take root in the country and potentially unleash a supply of securities for lending.

CIMB-Principal Asset Management and HSBC are the two firms involved, and are understood to be approaching the regulator to determine whether ETF managers can share sec-lending revenue with custodians, or lending agents. This would better enable them to lend out stocks underlying the physical exchange-traded funds they manage.

The lack of clear guidelines on sec-lending has long been blamed for holding the practice back in Malaysia, given that managers and custodians view such compensation as a prerequisite before investing in the required infrastructure.

“A manager needs [sizeable scale of business] to make securities lending work effectively,” says Raymond Tang, regional CIO of CIMB-Principal Asset Management, which manages four ETFs, two of which are listed in Singapore.

“For managers starting out, investing in additional infrastructure can be expensive. Hence the fees earned [from sec-lending] have to be [high enough] to pay off the additional infrastructure cost.”

The ETF industry in Malaysia is tiny, with just four equity funds and one fixed income fund listed on Bursa Malaysia, notes Karu Ramesh Kumar, associate director of equity financing services at CIMB Investment Bank.

He agrees that industry lobbying is needed to determine whether fund managers can share sec-lending revenue with lending agents.

If managers are given permission to share this revenue, both asset managers and their custodians/agents will be more incentivised to invest in the required front/back office systems for sec-lending.

“ETFs and sec-lending are relatively new in Malaysia,” Karu says. “There is a general lack of awareness and understanding that sec-lending is a key avenue where fund managers can deliver above average returns to ETF unit-holders, and also as a tool to ensure an ETF efficiently tracks the performance of the underlying indices.”

ETF managers in the US and Europe have long used securities lending as a way to enhance shareholder returns.

State Street and BlackRock both use affiliates as sec-lending agents for their ETFs. State Street also acts as custodian of its SPDR series of ETFs.

But the practice of using an affiliated business as a lending agent has also highlighted potential for conflict of interest.

Two pension funds in the US, from Nashville and Cincinnati, are currently suing BlackRock, alleging that its affiliated lending agent retained excessive fees from sec-lending for a number of US-listed iShares ETFs they invest in.

Of course, in Malaysia this is less of a concern, given that managers do not appoint related parties as custodians or trustees of their ETFs. To do so they require special approval from the SC (in other words, it is discouraged).

In its 2012 annual report, BlackRock disclosed that its affiliated lending agent retained 35% sec-lending income as fees. For its iShares S&P 500 Index, for example, its affiliated lending agent earned $1.87 million in fees and generated $3.5 million sec-lending income for the fund in 2012.

“In the US, the fees are shared between the ETF fund manager and the agent lender, to compensate for all the investment and work such as risk monitoring that the fund manager must put in for sec-lending,” says Karu.

Karu estimates that equities available for lending in Malaysia stand at RM100 billion, while actual on-loan securities amounted to little over RM1 billion.

He suggests that once an ETF reaches RM100 million ($32.4 million) in net asset value in Malaysia, managers could consider lending out up to half of their portfolio.

Once there is a more consistent supply of securities for borrowing, he notes, custodians will be more willing to invest in infrastructure and systems to support this business.