HISA ETFs now subject to stricter liquidity rules

The Office of the Superintendent of Financial Institutions (OSFI) is raising liquidity requirements for high-interest savings account ETFs, a move that may affect the rates offered on the popular products.

Banks that hold deposits for high-interest savings account (HISA) funds will have to hold “sufficient high-quality liquid assets, such as government bonds, to support all HISA ETF balances that can be withdrawn within 30 days,” the regulator said on Tuesday. The liquidity treatment must be in place by Jan. 31.

Fund manufacturers said they’re disappointed with OSFI’s new rules, given HISA ETFs’ popularity and use as a savings tool, but were confident the products would maintain their appeal.

“I was hopeful their assessment would be a little bit different,” said Raj Lala, president and CEO of Evolve ETFs in Toronto, which manages the $5.3-billion High Interest Savings Account Fund.

OSFI announced in May that it was reviewing banks’ liquidity adequacy requirements to determine whether new categories of wholesale funding are needed “to appropriately reflect the risks” of products such as HISA ETFs, which have been enormously popular over the last 18 months.

The regulator noted that HISA ETFs provide a high degree of liquidity as withdrawals usually aren’t subject to restrictions. The review came in the wake of high-profile bank failures in the U.S., where runs on deposits were unusually fast.

Banks’ liquidity coverage ratio (LCR) rules describe run-off rates for different types of deposits based on how stable they’re perceived to be.

Retail deposits, where an individual typically has a relationship with the institution covering various banking services, are seen as less likely to be hit with mass withdrawals during times of market stress. The run-off for different classifications of retail deposits ranges from 3% to 40%.

Unsecured wholesale funding, which covers deposits from organizations such as small businesses and financial institutions, may see more rapid withdrawals. The run-off rate ranges from 5% for small businesses to 100% for securities firms.

OSFI said Tuesday that banks will have to classify deposits from HISA ETFs as unsecured wholesale funding with 100% run-off.

“Despite some retail-like characteristics, the wholesale funding products OSFI analyzed during our consultation are held directly by fund managers for purposes that are not specifically operational,” the regulator said.

Vlad Tasevski, chief operating officer and head of product with Purpose Investments Inc. — which manages the $5.6-billion Purpose High Interest Savings Fund — said he was “extremely disappointed” with the outcome, which he said doesn’t reflect the stability of the HISA ETF deposits.

Banks have their own policies for classifying deposits from HISA ETFs based on the institution’s entire deposit book. According to TD Securities, National Bank is the largest deposit taker of HISA funds at $13.5 billion, followed by Bank of Nova Scotia ($6.9 billion), CIBC ($5.8 billion) and Bank of Montreal ($1.0 billion).

With HISA ETFs offering gross yields between 5.3% and 5.5%, TD Securities said most banks are likely applying a 40% LCR run-off rate to the products. Yield is likely to drop by 0.5% to around 5% after the new rules take effect on Jan. 31, TD said in a report released Tuesday.

Lala, Tasevski and Rohit Mehta, president and CEO of Horizons ETFs Management (Canada) Inc. — which manages the $3.9-billion Horizons High Interest Savings ETF — said it’s too soon to say how rates will be affected by the liquidity requirements. They’ll be meeting with their partner banks in the coming days to discuss the impact.

However, Lala said HISA ETFs will still be “the best products out there when you factor in yield and liquidity and credit risk.”

In explaining the decision, OSFI said that banks’ relationships are with ETF funds and not with retail investors in the funds. While HISA ETFs are marketed to retail investors, the funds are traded on an exchange and there’s no way to prevent pension funds or money-market funds from acquiring them.

TD Securities predicted that banks would adjust without affecting the HISA ETFs. Because Canadian banks and HISA issuers have long-term contracts to ensure the deposits’ stability, “there shouldn’t be any immediate concerns triggered as a result of the OSFI review,” the report said.

OSFI’s review shook up the investment product landscape in Canada before the new liquidity rules were announced on Tuesday, as issuers worried about how revised rules might affect the rates they offered. Some big banks also don’t allow HISA ETFs to be traded by their discount brokerages.

Manufacturers offering HISA ETFs as well as other competitors have launched money-market funds with slightly lower rates but that don’t rely on bank deposits.

Looking at fund flows, it’s easy to see why. Last year, assets under management (AUM) in cash alternative ETFs more than doubled to $15 billion, according to National Bank Financial (NBF), as investors sought safety and benefited from the highest interest rates in years.

By Sept. 30 this year, HISA ETFs had $21.9 billion in AUM, a report from NBF said (a figure that jumps to $29 billion when mutual funds are included, according to TD Securities). Money-market ETFs had $3.1 billion in AUM on Sept. 30, per NBF.

Mark Noble, senior vice-president of retail strategy with Guardian Capital LP — which released two short-term T-bill funds in July and doesn’t offer HISA ETFs — said the change may signal that “the party is over” for HISA ETFs.

The requirements will cut into HISA funds’ competitive advantage, he said, with some T-bill or money-market funds potentially offering higher yields.

“I don’t think we’ll see a wave of redemptions,” Noble said, but new money may find its way to competing products.

Even under the new liquidity rules, TD Securities said HISA ETFs maintain certain advantages over competing products while interest rates are high. Most banks offer less than 3% on high-interest savings accounts, the report said, while investors sacrifice liquidity when they buy GICs.

While money-market and ultra-short-term bond funds offer attractive yields, “its important to note that these ETFs hold securities and are subject to price changes based on interest rate changes while the NAV of cash ETFs is more stable,” TD said.

Lala said investors’ time horizon will be an important factor. HISA ETFs have zero duration, the credit risk is that of Canadian banks and liquidity is daily. “If you’re looking for a true cash alternative, these products are going to remain the best option for investors,” he said.

With clarity around the rules, Lala and Mehta said they hope other banks will become deposit takers for HISA ETFs.

“Since this OSFI review started, the banks have not been opening new accounts for other firms,” Mehta said. “With that clarity, now everyone can grow knowing this is the guidance for the foreseeable future.”

Lala said the products provide a way for banks to diversify their product base without the cost of customer acquisition, which is borne by the fund company.