Roy Zimmerhansl, owner of FinTuition and editor of Global Securities Lending and Investor Services Journal, discusses counterparty exposures in exchange-traded funds with Paul Amery, editor of IndexUniverse.eu.

IU.eu: Roy, investors face counterparty and collateral exposures in both specie and swap-based ETFs. Is it fair to say that the differences between the two types of structure are more apparent than real?

Zimmerhansl: Both types of ETF have collateral and counterparty risks: they are just in different locations. The differences relate to whether these risks are the result of frontline or secondary activities, and whether they are disclosed or undisclosed.

If you look at a physically replicated (or “cash-based” or “in specie”) ETF, a typical fund is involved in securities lending. Apart from certain information that might be given in an ETF’s year-end report and accounts, there’s typically no disclosure either of the counterparties to whom securities are lent, or of the actual collateral received in return.

Without counterparty disclosure it’s not possible to know to whom you might be exposed. If you know the names then the credit derivatives market can help to give you a feel for the perceived riskiness of the institutions concerned. And while a daily snapshot of collateral would be useful, it’s probably more important to have a clear statement of policy: limits on the duration of exposures, asset class guidelines, whether an external manager is being used to manage collateral, for example.

IU.eu: What about swap-based ETF structures? Presumably you have a better idea here of counterparty risk?

Zimmerhansl: I think that the interesting thing with swap-based ETFs is that while under the UCITS rules the aggregate counterparty exposure is limited to 10% of net asset value, in practice there’s quite a diverse range of policies among ETF issuers. They don’t all reset their swaps at the same trigger points: some allow bank counterparty exposures to reach 10%, others even overcollateralise them.

There are also differences between ETFs run on a consortium model, using a range of swap providers. Some – Source, for example – insist that none of the consortium members can provide collateral that’s tied to the other consortium members, while others don’t enforce such a rule.

IU.eu: Is it important where the collateral is actually held, whether with a central securities depositary or the fund custodian?

Zimmerhansl: I don’t think there’s a big difference here. In a typical ETF structure the custodian is properly segregated from the issuer.

IU.eu: You mentioned at a recent seminar that securities lending income is falling, meaning that ETFs may face increased tracking error. Is the importance of stock lending for ETFs decreasing?

Zimmerhansl: Securities lending has good years and bad years, like any other business. The last two years – 2008 and 2009 – were better than they should have been. Although overall lending volumes were well down from 2007 levels, and the interest rates on offer to make extra returns from cash reinvestment were also well down, there were many special situations offering very high lending revenues – in Citibank shares, for example.

However, not that many ETFs held the right shares to benefit from these special situations. So it’s difficult to make general predictions and you have to look on a fund-by-fund basis.

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