As Cris Heaton explains in his latest Asia roundup, it’s now impossible to mention a synthetic ETF in Hong Kong without adding a new risk warning. What was once the iShares FTSE A50 ETF is now the iShares FTSE A50 China Index ETF* (*This is a synthetic ETF). The asterisk and the following phrase in brackets have been obligatory for all derivatives-based ETFs since mid-January.
On the face of it, Hong Kong’s regulators appear to be responding to public concern about embedded counterparty risks in financial products. This is a highly sensitive subject in the former British colony, since over 30,000 locals lost money after investing in Lehman “minibonds” in 2008, and demonstrations by aggrieved investors still continue. Several banks involved in the distribution of the minibonds have since paid compensation to affected investors.
In Hong Kong’s ETF market, counterparty risk concerns arise most obviously when it comes to funds offering exposure to China’s domestic A shares market.
Foreigners can’t buy A shares directly, so they have to buy them in the form of “China A share access products” or “CAAPs”, which are derivatives contracts written by banks with access to A share quotas. Incidentally, this barrier to direct access causes frequent and persistent price premia in A share ETFs (the premium to NAV for iShares’ A50 ETF is currently around 10%, according to Bloomberg).
iShares’ Hong Kong-listed A50 ETF is the biggest fund of this type, with nearly US$7 billion under management. With an expense ratio of 0.99% a year, it generates a healthy income for its fund manager, BlackRock.
However, under Hong Kong’s liberal rules on counterparty exposure, most of the derivatives exposure in the iShares A50 fund is uncollateralised. There is a limit of 10% of NAV when it comes to net exposure to a single derivatives counterparty, but no overall limit. In theory you could have ten counterparties, each issuing CAAPs representing 10% of the fund’s value, and no collateral at all. Currently, collateral exists to back around 25% of the fund’s value, but the rest of the exposure is naked.
In Europe, such a fund would not comply with the UCITS rules that govern the use of derivatives by funds, and could therefore not be marketed as an ETF. The UCITS rules specify that net exposure to derivatives counterparties may not exceed 10% in total.
In fact, many European ETF issuers now overcollateralise their funds, meaning that (in theory at least) if the derivatives counterparty goes bust, your money is safe.
In Hong Kong, by contrast, you could in theory lose 75% of any cash invested in the iShares A50 fund if all its CAAP issuers failed to fulfil their obligations. The regulator’s insistence on having a maximum of 10% risk exposure to any single counterparty is some protection, one might argue. Then again, if one global investment bank fails, what’s the chance of a chain reaction affecting all others? Quite high, I’d say.
You can't blame iShares for collateralising its Hong Kong A50 fund to a lesser extent than it does for its European swap-based ETFs, since the Hong Kong rules allow them to do this, and providing collateral costs money. But when other European swap-based ETF providers, who stick by the stricter UCITS rules for the funds they market in Asia, argue that it’s not a level playing field out there, I have sympathy.
More importantly, the Hong Kong regulator's new rules on labelling swap-based ETFs with what amounts to a risk warning totally ignores the overall level of collateral backing such funds may provide. All synthetic ETFs are lumped in together, from those that are completely collateralised to those that have largely unbacked exposure.
The local authorities don’t want to tighten up the rules on derivatives because that would impact the highly lucrative warrants market, which generates around 20% of the local exchange’s turnover, one Hong Kong-based ETF market observer suggested. If you buy a derivative warrant in Hong Kong and its issuer goes bust, you end up as an unsecured creditor and you can probably kiss goodbye to your money.
But by imposing heavy-handed naming rules for synthetic ETFs while ignoring naked derivatives exposure in other retail investment products, Hong Kong’s regulators risk accusations of hypocrisy.