We have many times in the past--in our reports, articles and webinars--discussed the investor protections inherent to most exchange traded products (ETPs). In my article published last July, Synthetic ETFs: How Protected Are You?, I highlighted the need for improved transparency in swap-based ETFs, especially as it pertains to collateral policies, in order for investors to fully assess the counterparty risk they face in this type of ETFs. Although its aim wasn’t to be comprehensive, that article failed to distinguish between the many structures currently employed by various providers of synthetic ETFs across Europe as well as the risks associated with them. This will be addressed in the coming weeks with the publication of a comprehensive report outlining and scrutinising all the various practices employed by swap-based ETF providers in Europe (if you are interested in receiving a copy of this report please send an e-mail to etfqueries@morningstar.com). Meanwhile, I thought I’d give our readers a sneak peak into the part of our report dealing with structural risks.
Assessing these risks is actually not as straightforward as we would have wished as the practice actually appears much more complex than the theory, hence a few misconceptions in the minds of some investors.
Given the variety of structures used to synthetically replicate an index, investors should be aware of the differences between the various legal arrangements in place as they will determine the procedure that will be followed in the event of a counterparty default. I must admit that here we are entering legal territory where we often hear that the devil is in the details.
In an effort to simplify the debate between the defenders of each model, it’s said that the safety of a swap-based ETF may depend on the type of swap used by the provider, whether it’s funded or unfunded, and more particularly on how the collateral is held and who owns it. These two considerations may have an effect on the treatment of the collateral following a default. For example, it may affect the timing of a potential liquidation of the assets.
Under the unfunded swap model, investors’ cash is used by the ETF provider to purchase securities, which will constitute the “holdings” or “substitute basket” of the fund. So it’s clear in this structure -adopted by Lyxor, Amundi, EasyETF, Credit Suisse, Source, ETF Securities*, a portion of db x-trackers’ ETF lineup and RBS- that the fund owns the assets. This direct access to the assets means that the ETF provider will be able to liquidate them swiftly should this option be chosen in the case the counterparty goes under.
The funded swap model has more intricacies. Under this structure, investors’ cash is transferred to the swap counterparty who posts collateral into a segregated account with an independent custodian. The subtleties lie in the fact that the collateral may either have legal title transferred to the fund or be pledged for the benefit of the fund.
iShares, UBS, ETF Securities* and XACT are among the users of funded swaps who have a transfer of title in place. Under this arrangement, the assets provided by the counterparty as collateral are in the name of the fund and treated as the property of the fund. In theory, this means that the fund can gain access to them without prior approval. As a result, in a default scenario, the fund would have the right to instruct the collateral agent to transfer the collateral from the segregated collateral account to the fund’s custody account. Collateral would then be disposed of in the best interest of investors.
In the case of a pledge structure--used by roughly half of db x-trackers’ ETFs--the collateral is typically posted to a pledged account in the name of the counterparty for the benefit of the fund. If the counterparty goes bankrupt, the pledge would need to be enforced, which could in theory lead to a delay in liquidating the fund if the bankruptcy administrator decides to freeze the assets. This scenario occurred with some Lehman contracts. However, db X-trackers has an arrangement with its custodian and collateral manager under Luxembourg law that entitles its funds to appropriate collateral assets and liquidate them without prior notice to the counterparty or any other third parties. This degree of enforceability should serve to lessen some investors’ concerns over db X-tracker’s specific pledge structure.
After many discussions with a wide variety of market participants about the issue of structural risks in swap-based ETFs, I have come to the conclusion that trying to compare the various structures to determine whether one is safer than another may prove to be a wild-goose chase. In fact, ETF providers shouldn’t try to compete by stating that their swap structure is legally stronger than others because they are all using standard techniques known to work well in practice, even though some might sound “safer” in theory.
* ETF Securities employs both funded and unfunded swaps at the same time for its synthetic ETFs.
