* All revenue from lending must be returned to investor
* Applies to UCITs and UCITs ETFs
* Stricter collateral rules
By Anjuli Davies
LONDON, July 25 (Reuters) - European fund firms could lose out on revenues under new European Union rules to toughen up supervision of securities lending published on Wednesday.
Securities lending is commonplace in the mutual fund industry globally as a means of boosting revenue as well as reducing management fees.
Under European markets watchdog ESMA's proposals, all revenues generated by securities lending will now have to be returned to investors in the funds and there will be stricter requirements about the types of collateral posted.
"These guidelines are a valuable response to many of the issues identified in the ongoing debate on shadow banking and will constitute an important step in the development of the regulatory framework of UCITS," Steven Maijoor, chair of ESMA said in a statement.
UCITS -- Undertakings for Collective Investment in Transferable Securities -- is a European regulatory framework that allows funds to be sold in any European Union country after approval from a single member state.
The European Commission pledged in April to tighten control of so-called shadow banking, answering central bank calls for stricter regulation of the sprawling 46 trillion euro sector which has been blamed for aggravating the financial crisis.
Hedge funds and private equity are often cited as examples of shadow banking, although the term is not clearly defined and can also take in investment funds, insurers and other entities.
ESMA has been looking separately at regulation of exchange-traded funds, or ETFs -- funds tracking baskets of shares, bonds or commodities that are traded like stocks.
According to Markit Securities Finance estimates, funds have more than $12 trillion of lendable inventory in lending programmes, of which $1.7 trillion is currently out on loan.
Funds lend out securities to outside investors -- hedge funds betting on a fall in an equity index by short selling shares, for example -- in exchange for collateral and a fee.
The practice is also becoming more popular with ETFs as the $1.7 trillion industry grows in size, with the extra revenue compensating for slim profit margins as the race to reduce costs for investors has intensified.
Such funds have become increasingly popular among retail investors seeking cheap access to indices without having to buy the underlying securities.
As part of final guidelines to regulate the European ETF industry, presented in draft form in January, ESMA found that the practice of securities lending needed to be assessed across all funds sold in Europe under the UCITS brand.
Revenue sharing practices from lending out securities vary across the industry and some critics argue that investors in the funds are not fully reaping the rewards whilst at the same time being kept in the dark as to the risks. These include the risk the counterparty that borrowed the security will default and fail to return it as pledged, leaving investors in the fund to shoulder the loss.
There are also concerns over the risk of losses when a fund manager reinvests excess collateral from securities lending, which also entails a counterparty risk. ESMA has listed assets that are eligible for investment and limited the exposure to any one single counterparty to 20 percent.
Some ETF providers are seeking to make the practice more transparent.
Blackrock's iShares, the world's largest asset manager and ETF provider, reports its securities lending operations on a daily basis on its website where investors can also see the underlying collateral holdings for each Dublin-domiciled fund.
In June, it set a new limit for the amount of assets it would lend out to a third party -- 50 percent of the underlying basket of assets it holds in any ETF -- and said it would indemnify investors if a counterparty defaulted on a loan.
The firm also said 40 percent of revenue earned from securities lending goes to Blackrock, whilst 60 percent is returned to investors. In the second quarter of the year, Blackrock generated $157 million in securities lending fees compared with $134 million in the second quarter 2011.
"Whilst we concur that investors should have a clear understanding of the risks associated with ETPs (exchange-traded products), including counterparty and market risk, we also believe that investors should be made aware of the potential benefits that activities such as securities lending can bring to them," Joe Linhares, head of iShares EMEA, said in a statement.
In contrast, Vanguard Group already puts 100 percent of securities lending revenue back into the fund, minus associated expenses.
In March, the International Organisation of Securities Commissions (IOSCO), the global markets regulatory group, said in a consultation paper the implications of securities lending went far beyond the ETF industry and that more disclosure surrounding fees and risks were needed.
The new EU rules won't come into force until a new consultation open until September on repo and reverse repo arrangements launched by ESMA is completed. (Reporting by Anjuli Davies; Editing by Catherine Evans)