In three separate documents released last week the Financial Stability Board (FSB), International Monetary Fund (IMF), and Bank for International Settlements (BIS) all voiced concerns about the potential risks to financial stability posed by exchange-traded products (ETPs).
In its note, released last Tuesday, the FSB highlighted the “the speed and breadth of financial innovation in the ETF market” as having “brought new elements of complexity and opacity into this standardised market.” The regulator also highlighted concerns over the counterparty risks inherent to ETPs and the potential that the vehicles’ “on-demand” liquidity could threaten their sponsors’ solvency. In the words of the FSB:
“The increased popularity of “synthetic” ETFs (which use derivatives) as well as the more intensive recourse to securities lending by ETF providers of plain-vanilla ETFs raises new challenges in terms of counterparty and collateral risks. In addition, the expectation of on-demand liquidity may create the conditions for acute redemption pressures on certain types of ETFs in situations of market stress, which could in turn affect the liquidity of the large asset managers and banks active in this market.”
Separately, the IMF raised similar concerns within its “Global Financial Stability Report”. Synthetic replication techniques are also under the IMF’s microscope, “given that a majority of European ETF providers use the synthetic replication method, the gross exposures of these funds raises some concerns on whether current restrictions on derivative contracts are sufficient to curtail counterparty risks from becoming systemic under stressed market conditions.” The IMF’s report also highlights risks stemming from securities lending within physical replication funds as well as spending time on the limited suitability of leveraged and inverse products.
The BIS also chimed in later in the week. In its paper, the Basel-based organisation expresses concerned that, “[synthetic] replication strategies can lead to a build-up of systemic risks in the financial system.”
iShares, the world’s largest ETF provider, was the first to respond to the volley of warnings from the global super-regulators. Joe Linhares, the Head of iShares EMEA commented, “It is encouraging that the FSB calls not just for transparency but also for providers to evidence to investors a demonstrable infrastructure to support transparency.” Later in the week ETF Securities issued its own statement which also welcomed the FSB’s comments and echoed the call for increased transparency and education within the ETP arena. The firm also committed to regularly publishing the collateral held for its ETF range on its ETF Exchange (ETFX) platform in the coming weeks. Most recently, Manooj Mistry, Head of db x-trackers UK, stated that his firm also “welcome(s) this attention” and underscored the need for the industry to “establish common standards” as it pertains to providing transparency around the management of swap-based ETFs.
For our part, we have been calling for increased transparency for some time now and working to highlight and educate investors on the risks inherent to all varieties of ETPs. This round of warnings from a trio of global regulators will undoubtedly place fresh pressure on the industry to establish and follow a set of best practices surrounding the disclosure of collateral practices in the case on swap-based funds as well as providing more insight into securities lending within physical funds. Already, we have seen ETF Securities step forward and commit to more regular disclosure—something we had called for last year in our first high-level assessment of the various synthetic structures employed by providers. We expect others will soon follow suit.
In May, we will be publishing a comprehensive report outlining the basic mechanics of synthetic ETFs and closely scrutinising the current practices employed by the various providers of swap-based products. Our report aims to highlight best practices pertaining to structure, collateral management, and transparency and should serve as a useful guide for a broad spectrum of investors seeking to better understand how these products are built and how providers both inform them of and protect them from counterparty risk. If you are interested in receiving a copy of this report, please send an e-mail to etfqueries@morningstar.com.
New Launches
iShares launched a suite of physically-backed precious metals products last week. The iShares Physical Gold ETC (LSE ticker: SGLN), iShares Physical Silver ETC (SSLN), iShares Physical Platinum ETC (SPLT), and iShares Physical Palladium ETC (SPDM) are all listed on the London Stock Exchange. The products are structured as exchange traded commodities (ETCs), which take the form of limited recourse debt obligations which are backed by their respective physical metals.
At 0.25%, iShares new gold-backed ETC boasts the lowest total expense ratio (TER) of any physically backed gold ETP. This is 4 basis points better than the annual fee levied by the db Physical Gold ETC (0.29%, XGLD) which was listed on the LSE last June, and 15 basis points less than that charged by the most popular physically-backed gold ETC in the UK, ETF Securities’ Physical Gold ETC (PHAU)—which has a TER of 0.39%. Given the nature of physically-backed ETCs, TER is a crucial differentiator from the perspective of a long-term buy-and-hold investor, as seemingly minor discrepancies in carrying costs will compound over time.
iShares’ move to undercut its competitors’ fees mimic the move it made with its US domiciled iShares Gold Trust ETF (IAU) last July. The world’s largest ETF provider slashed IAU’s expense ratio from 0.40% to 0.25% last year, undercutting its larger rival SPDR Gold Shares (GLD), which has an expense ratio of 0.40%. Based on Morningstar’s Estimated Fund Flows data, the move has done little to siphon assets away from GLD in the U.S. and we anticipate that investors in the UK will show a similarly tepid response to the newly crowned low-TER leader in what is a crowded market for physically-backed gold funds.
The iShares Physical Silver ETC also takes the prize for lowest TER amongst all existing physically-backed silver ETPs within Europe, with a TER of 0.40%. Meanwhile, the iShares Physical Platinum ETC and iShares Physical Palladium ETC boast the lowest TER (0.40%) amongst similar London-listed ETPs.
Source launched a new ETF focused on the Eurozone bank sector last week. The EURO STOXX Optimised Banks ETF joins the firm’s existing roster of 18 European optimised sector ETFs. In a press release the firm stated, “the relative performance of Eurozone banks, especially Spain, versus other European banks has highlighted a need in the market for a liquid, tradable ETF on the Eurozone banks sector.” The ETF has a TER of 0.30% and is listed in euros on the Deutsche Börse.
Best and Worst Performers
For the second consecutive week the list of best performing ETPs was dominated by physically backed silver products. Silver prices advanced for the fourth week in a row, nearly touching the $43 mark and representing a fresh 31-year high. A combination of inflation and sovereign debt fears continues to propel precious metals higher. Meanwhile, lead led the list of the week’s biggest fallers as prices for the industrial metal fell like—well—a lead balloon.
