February 2010

ETFs: counterparty risk

The success story of ETFs has not been brought to a halt. But counterparty risk associated with them has been thrust into the limelight, writes Angèle Spiteri Paris

halo.jpgSwap-based exchange traded funds (ETFs) caught a lot of flak for the inherent counterparty risk within their structure, but physical ETFs did not get off easy either. The physical funds, which hold securities rather than relying on derivatives, caught attention because they are involved in securities lending.

These added layers of risk suggested that perhaps both types of ETFs were not quite the simple, innocent products they seemed to be. Investors are strongly urged to read the fine print (which they should be doing anyway).

Although ETF providers introduced measures to calm these fears, in some cases it seems opacity may still prevail and fail to calm worries.

As ETFs gained popularity, the different types of vehicles available came under scrutiny. The ETF world can be, simplistically, divided into two camps – the fully physically replicated funds, and the synthetic ones that use swaps.

Both types of ETFs come with some level of counterparty risk, either due to a swap or because the securities are lent out. All the detail of how these transactions are carried out can be found in a fund’s prospectus. But investors were not always aware of their implications when they chose to invest in a particular ETF.

Chris Sutton, senior investment consultant at Towers Watson (the newly merged Watson Wyatt and Towers Perrin) says: “Our main concern with ETFs is that investors did not buy the product to take these kinds of credit risks.”

Especially if they’re not being sufficiently remunerated for their exposure.

Sutton says: “At the moment returns from securities lending are not that high. So this practice is delivering a relatively small return and adding on an extra layer of risk which I don’t think the holder of the ETF ever wanted in the first place.

“It’s not clear to me that the ETF holder is being adequately compensated for that risk. At the same time the ETF sponsors claim that this actually lowers the fee of the ETF, which I think is double counting. The fee is lower because you’ve taken the counterparty risk in the first place.”

Whatever the reason, and whether the fee is lower or not, the fact remains that there are added risks embedded in products marketed for their simplicity and transparency.

Transparent opacity
The investment process of ETFs is indeed transparent but when it comes to dealing with the practices that go on within the actual product, providers may not be as forthcoming.

Sutton says: “Very often that transparency falls down a bit when you get down to discussing the business of what goes on with the collateral in stock lending or swaps. Sponsors are not particularly forthcoming on how they manage that.”
Sutton refers to providers of physical ETFs as well as the synthetic ones.

One industry player comments specifically on swap-based ETF providers, saying: “Historically they have not been providing that level of detail, in terms of what’s in the portfolios. Although some have been trying to get better.”

Providers of swap-based ETFs have a different view.

Manooj Mistry, head of equity ETF structuring at Deutsche Bank’s db x-trackers, says: “People make a lot of noise about counterparty risk on ETFs, especially the synthetic ones, but I think its over-exaggerated. All these products are governed by Ucits so these funds are thoroughly managed and have robust procedures in place.”

The ETFs offered by db x-trackers are all swap based.

Historically, there was no collateral held against the swaps. Mark Weeks, chief executive of the ETF Exchange at ETF Securities, says: “The potential downside for the investor under most second-generation models is that you have the counterparty risk to that swap provider. You need to make sure that you’re happy with that counterparty risk because if there’s a default then the investor will have to queue up with all the other creditors to get their money back from that investment bank.”

Some firms have begun to put up collateral against those swaps, in an effort to go one step further to protect investors.

Mistry, at db x-trackers, says: “Some providers, like Deutsche Bank, have overlaid their own limits and rules in terms of how much exposure. For example, for most of the equity ETFs we have a process where we have a fully collateralised net asset value (NAV).”

This was introduced in March last year after investors raised concerns about counterparty risk following the collapse of Lehman Brothers.

Mistry explains how this works. “To comply with the Ucits regulation advocating a maximum 10% exposure to any single counterparty, the swap exposure must be collateralised. So the swap counterpart delivers assets into a ring-fenced account with the custodian for that collateral to act as security.”

He says that according to Ucits rules a minimum of 90% collateral is required but in db x-trackers’s fully collateralised ETFs, the collateral accounts for around 103-105% of the NAV.

Db x-trackers has 75 ETFs under the fully collateralised NAV structure.

Mistry says that Deutsche Bank is the only counterparty for db x-trackers. Questioned whether this has ever raised an eyebrow with clients, he says: “They ask the question but normally once we explain to them that we have the fully collateralised NAV structure, people are quite comfortable with it. Since there’s collateral sitting in the fund, their concerns are mitigated somewhat.”

But Weeks, at ETF Securities, says: “One of the weaknesses of the second-generation ETFs [swap-based products] is that if you only have one swap counterparty, they control many aspects of that fund. They’re the issuer, the approved participant, swap provider, controlling most aspects of the fund itself. So if you have a default, although your assets may be ring-fenced in a Ucits III fund, it could take you months to take them back out.”

One thing that can help investors rest easy though is that the collateral that db x-trackers holds in the ring-fenced account is not itself lent out.

Mistry says: “In some of these other models there is lending going on so you’re introducing a further element of risk into this.”

Weeks says: “This does add another layer of risk. If you mitigate the investors’ risk by providing collateral and then proceed to lend that out you actually reduce the benefit of holding that collateral…

“It can make sense in a lot of ways, at least from a financial perspective. It’s another opportunity to increase your return. If the way you structure that collateral is more of a pledge – it belongs to the fund, in the event of default – then there is the possibility that you can lend that collateral out.”

All of the experts heard that this practice is being carried out, but none were willing to name any firm that does this. According to their prospectus, db x-trackers reserves the right to lend out the collateral, but has never done so.

The lending out of collateral held against a swap could raise alarm bells with some investors, but Sutton, at Towers Watson, says: “You get the exact same issues [in terms of risk].”

This is because the ETF provider would then take collateral in return for lending out those assets. This once again throws up concerns about additional counterparty risk and the way that collateral is managed.

This is all fine if nothing goes wrong, but in the case of a default on behalf of the investment bank that wrote the swap, things could get very complicated if the collateral held to guarantee that swap were lent out.

So, securities lending within ETFs comes with risks, be it done using collateral or the securities of the fund itself.

Lending concern
At first glance swap-based ETFs seem to have more counterparty risk exposure than physical ETFs. But one would be wrong to assume there are no counterparty concerns when it comes to these products.

The practice of securities lending in the realm of physically backed products has had criticism in its own right. Concerns have been raised about the counterparty risk investors are exposed to when the assets within an ETF are lent out.

Weeks says: “They [physical ETF providers] have liked the claim that there is no counterparty risk under that structure, but I would point out that there is risk under every structure.”

Deborah Fuhr, head of global ETF research at  BlackRock, believes the argument against securities lending is more about scaremongering. She says: “The reality is that most mutual funds have done securities lending for a very long time and it’s a regulated activity under the Ucits guidelines. It’s not like ETF funds are doing something that is inappropriate.”

She suggests it’s more about the swap-based providers trying to counter the fact that people have been concerned about the counterparty risk that is involved when using swaps.

Regardless of the basis of the argument against securities lending within ETFs, some providers of physically backed products have begun to over-collateralise, claims a source, who did not wish to be named. They ask for more collateral than necessary when carrying out securities lending on physical ETFs.

Having collateral sitting in a segregated account is all well and good, but Sutton says the credit risk around those collateral pools is one of the most worrying aspects.

He says: “The collateral pools can be invested in a wide variety of things. In swap transactions it depends on the terms of the swaps while in securities lending they’re often invested in short-term bonds and money market-type instruments.

“The concern is that a bond- or mortgage-backed security held as collateral defaults is worthless and at the time when you need that collateral you haven’t got it.

“The worst-case scenario is a collateral pool where the risk is too high and it’s poorly managed and that there is a default.”

Although this is most definitely an unpleasant scenario it seems that the chances of it becoming a reality are actually quite slim. Tim Mitchell, head of specialist funds at Invesco, says: “You can’t extinguish risk completely and these kinds of risks are exceptionally small. You’ve got to put them into context.”

As a result of Ucits regulation, an ETF cannot have more than 10% exposure to any one counterparty. Therefore investors can, technically, only lose 10% of their investment if one counterparty goes bust.

Mitchell says: “If you look at these funds you’ll find that there is a risk process involved in picking a counterparty. They’re not going to go to some strange group investors have never heard of to write the swap. The counterparties are going to be the big investment banks.”

According to Mitchell, something cataclysmic would need to happen for one of these banks to fall apart. “A 10% loss would be almost irrelevant at that point because the underlying asset prices would have collapsed as well.”

Weeks says: “It all depends on the quality of the collateral and the correlation of that collateral to the underlying ETF. If your ETF is tracking an emerging-market index, equity collateral from developed markets could be considered high quality.

“You have to highlight these risks but what concerns me is that too much emphasis is put on the low chance that something like this will happen.

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