Last week London-based ETF Securities announced the launch of its "ETF Exchange" platform, which it describes as the "world's first ETF issuer backed by a consortium". What is this new platform and why has ETF Securities chosen to launch it?

Hector McNeil, managing partner at the firm, explained that, first of all, the initiative is designed to improve on the traditional model used for European swap-based ETFs which, he said, tend to involve a single financial institution both as the "designer" of the ETF and as the counterparty writing the swap for the fund.

The new platform, McNeil said, would improve liquidity and enable more efficient fund distribution, and reduce concentration risk by moving away from the use of a single swap counterparty and towards a multiple swap provider model.

Over 15 banks and other financial institutions from across Europe have expressed a desire to join the ETF Securities consortium, according to the London-based firm.

McNeil argues that ETF Exchange should be seen as "an exchange for issuance", which will help address the fragmentation of ETF liquidity across different European markets. The new ETF model will use multiple, interchangeable counterparties to track the index, enabling investors to poll multiple market makers for the best price, and to get true competition and arbitrage, he continued.

The end result of the new model could be a radical rethink of the way the current European ETF market works, according to ETF Securities. To give an example of where this rethink might lead, McNeil highlights that there are currently ten or more European ETFs tracking the DJ Euro Stoxx index, all branded by different firms.  In the future, by contrast, there might be only one Euro Stoxx ETF, but with 10 different swap providers, among whom investors can choose.

In a presentation made to investors earlier this year, ETF Securities stated that it saw the move to a multiple swap counterparty model as a natural progression in ETF product design. Calling "in specie" ETFs—where the fund tracks the index by owning the underlying basket of shares, or a sample of them—the "first generation" of ETFs, and swap-based ETFs with a single swap provider the "second generation", ETF Securities argues that the multiple swap provider model is the third generation, with inherent structural improvements over its predecessors.

According to McNeil and his colleagues, the in specie ETF model suffers from a number of costs, leading to tracking error. These may include high delivery charges for baskets of stocks representing indices with a large number of securities, possible stamp duty charges within funds, and inherent cash drag due to time lags on dividend reinvestment. Risks in the in specie model, say ETF Securities, include some counterparty risk when the fund's securities are lent out, those resulting from use of derivatives for cash and dividend management or stock replacement strategies, and the lack of a delivery versus payment mechanism when ETFs are created in return for a basket of shares.

The second generation, or single swap provider model, offers guaranteed index performance, with lower rebalancing costs than an in specie ETF, argues ETF Securities, albeit at the expense of some counterparty risk exposure to the single swap provider. However, ETF Securities adds, this model has typically meant that all market makers have had to route trades through one authorised participant, typically the bank owning the ETF issuer, decreasing the efficiency of the arbitrage mechanism. The fact that the ETF promoter and the swap provider are typically the same financial institution means that, in the case of the bank's failure, there would be a high likelihood that the ETF would have to be liquidated, and assets returned to the investors, ETF Securities believes.

Therefore, the firm contends, the multiple swap provider model makes sense, as it ensures competition between counterparties and greater liquidity. It also incentivises a greater number of financial institutions to become involved in an ETF's sale and success, ETF Securities believes, as the bank that creates the ETF will typically get to write the swap, and the swap business has typically been a lucrative one; and, ETF Securities maintains, the existence of multiple providers ensures that, in the event of the failure of one counterparty, swaps can easilly be closed down and reallocated to other counterparties, reducing the operational risk of relying on a single bank.

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