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The federal banking watchdog has launched a review of cash exchange-traded funds, one of Canada’s most popular retail investments, amid a Bay Street spat that stems from surging demand for them.

The Office of the Superintendent of Financial Institutions, which regulates banks, launched its review in the fall and is studying any liquidity concerns posed by these ETFs, according to three financial industry sources. The Globe and Mail is not identifying the sources because they were not authorized to speak publicly about the matter.

Cash ETFs are hybrid funds that function like high-interest savings accounts, yet offer much better interest rates – around 4.99 per cent annually. These rates make cash ETFs similar to guaranteed investment certificates. But unlike GICs, which are sold on fixed terms, cash ETF investors can take their money out at any time, just like they could with bank accounts.

Cash ETFs are able to pay high interest rates because select banks offer them access to wholesale funding – that is, the banks pay the funds premium interest rates they would normally reserve for institutional clients, or for large orders. Similar rates would be available to wealthy retail investors who wanted to deposit millions of dollars.

This access has rankled some banks, according to the sources, because ETFs that offer premium rates to retail clients are likely to lure away customers from banks, hitting that sector’s profits.

The Big Six banks’ high-interest savings accounts currently pay an average of 1.5 per cent annually, which means funding deposits through cash ETFs is much more costly. That matters for the banking sector because mortgage loan growth is slowing. Better loan margins stemming from rising interest rates were expected to offset the lower volume.

If OSFI takes issue with cash ETFs, it could order changes that would lower the interest rates retail clients earn.

The majority of cash ETF assets are deposited with National Bank of Canada NA-T, Bank of Nova Scotia BNS-T and Canadian Imperial of Commerce CM-T.

Royal Bank of Canada RY-T does not provide funding for any cash ETFs, and Toronto-Dominion Bank TD-T has only minimal exposure. Both banks have blocked access to these funds on their online retail investing platforms.

OSFI confirmed the existence of its review in an e-mail to The Globe. “Cash ETFs, which have become very attractive to investors in light of the rising rate environment, are being reviewed by OSFI,” spokesperson Carole Saindon wrote. “In particular, we are focused on understanding the characteristics of this product from a liquidity perspective to ensure banks have appropriate treatment and are managing liquidity risk effectively.”

The regulator did not comment on what had prompted its review, or whether a specific bank had complained.

Every Big Six bank declined to comment on OSFI’s review, but the sources said that, in addition to the lower margins, some banks are concerned about how cash ETFs are structured.

Canada’s banks are heavily regulated, and there are now strict limits on how they fund their loans. Crucially, since the 2008-09 global financial crisis, OSFI has required them to fund more of their operations with highly liquid assets. Cash ETFs may not meet those guidelines.

Some banks have argued that cash ETFs pose no liquidity risk whatsoever, according to the sources.

The differences in the treatment of cash ETFs among the big banks may have to do with the compositions of their deposits. RBC and TD are Canada’s two largest banks, and they have massive, low-cost deposit bases. By contrast, Quebec-based National Bank does not a have a large retail banking presence in Western Canada, and expanding in the region by opening new branches would be a costly endeavour.

One alternative, then, is to attract deposits by partnering with fund companies. Although that requires paying a premium interest rate on the deposits, National – or any other bank – does not have to worry about the costly administrative burden of managing accounts, because that is outsourced to a fund company. Cash ETF providers typically charge a management fee of around 15 basis points in return. (A basis point is one hundredth of a percentage point.)

Although cash ETFs have been sold in Canada for years, they became incredibly popular after the Bank of Canada started aggressively hiking interest rates one year ago. Canadians poured nearly $9-billion into cash ETFs in 2022, and the funds are in even more demand this year. Cash ETFs are now the most popular type of fixed-income ETF, with $17.9-billion in assets under management. That amounts to 18 per cent of the nearly $99-billion that is invested in fixed-income funds, according to research from National Bank Financial.

The four largest cash ETFs are sold by CI Financial Corp., Purpose Investments Inc., Horizons ETFs Management (Canada) Inc. and Evolve Funds Inc.

Despite their recent popularity, cash ETFs still comprise a small fraction of total deposits stored at the Big Six banks. But they are projected to continue growing because interest rates are expected to remain elevated. At the same time, high-interest savings accounts have not moved in lockstep with the Bank of Canada’s rate hikes.

The last time the central bank’s interest rate was around 4.5 per cent, in 2007, retail banks’ high-interest accounts paid between three and four per cent annually, according data by Investor Economics, a unit of ISS Market Intelligence. Today, they pay roughly half that, or less.

In response to e-mailed questions about OSFI’s review, RBC and TD did not answer directly. Both said they periodically review their product offerings. TD added that its Direct Investing clients have access to the TD Investment Savings Account, which currently pays 4.2 per cent annually.

Dan Hallett, the head of research at HighView Financial Group, who has covered the fund industry for decades, sees similarities between the current spat and what transpired 20 years ago, when high-interest savings accounts from banks such as ING Direct (now known as Tangerine) became popular.

At the time, ING was able to attract deposits because Canada’s largest banks had stopped paying the competitive interest rates they used to offer in the 1980s and earlier.

“If I put myself in the position of a regulator and some banks are complaining, I’d say, ‘Well, why don’t you want to pay more competitive interest on your chequing and savings deposits?” he said.