iShares does disclose the revenue split between the fund manager (BlackRock) and the iShares funds (it used to be 50/50, then from November last year the manager took 10% of its cut and handed it back to fund investors, creating a 60/40 split). But as far as the transparency of the securities lending risk framework is concerned, the manager’s historical practices have left much to be desired.
For example, in the iShares plc annual report and accounts for 2009, on page 57 (under note 19, “securities lending income”) there’s a table of approved lending counterparties. However, while there’s a full list of counterparties that were in use on 29 February 2008, there is no list for 28 February 2009. Why the decrease in disclosure, year-on-year, for what is merely an annual snapshot of iShares ETFs’ lending relationships? “Because it’s not required by the Irish regulator,” I was told by an iShares spokesperson when I asked this question last year. So much for voluntary transparency.
The fund manager has recently started publishing a regular, more comprehensive review of its securities lending activities, in which counterparty names are once more disclosed (though the amounts on loan and revenues generated by each counterparty, valuable pieces of information for anyone wanting to assess risks, are not).
ETF—and securities lending—market practice is still far from the level of transparency that the regulators (and, I assume, most investors) would like to see. On the face of it, those synthetic ETFs that disclose their collateral basket daily are offering a far greater level of openness. In fact, in its ETF paper, the BIS analyses the db x-trackers’ MSCI Emerging Markets ETF on the basis of just this information, which is available on the issuer’s website. No one is yet able to perform an equivalent analysis where lending activities in a physically replicated ETF are concerned, as far as I’m aware.
Finally, the BIS ETF paper in particular looks in detail at the important differences between different varieties of synthetic ETF structures. In the unfunded swap structure, the ETF owns the assets in the collateral basket, while in the funded swap structure (a misnomer, according to the BIS, since no true swap is involved) the ETF investor only has a pledge of collateral from the counterparty. A pledge is only a promise to repay and there is the potential for investors in a funded swap ETF to face a lengthy delay if a counterparty fails and an administrator steps in. In the unfunded swap structure, outright ownership of collateral should allow you to step in and liquidate it at will in an emergency. (We covered this subject in some detail in an article in November, “A Swap-based ETF Checklist”).
But there are additional subtleties to consider. In the funded swap model investors typically benefit from a greater degree of overcollateralisation than when unfunded swaps are involved. Further, points out the BIS, the unfunded swap model gives the bank writing the swap (and transferring assets) leeway to alter its risk-weighted capital charges, while granting a pledge to the ETF doesn’t. This in turn implies economic incentives for the bank which may increase risks to the ETF end-investor (if the bank’s funding structure is compromised as a result of the widespread use of this practice).
How all this works out and which synthetic ETF model is likely to end up as preferred is unclear to me. I haven’t even discussed the multi-swap provider model used by Source and ETF Securities. Will this turn out to be a winner from the debate? I’d be interested to hear experts’ opinion on this—please leave comments at the bottom of this blog, rather than emailing me directly. Use a pseudonym if necessary!
There are plenty of more obvious points of discussion arising from this week’s regulatory onslaught. Perhaps the most interesting of these relate to possible systemic risks resulting from the widespread use of ETFs and a mismatch between investors’ perception of ETF liquidity and market realities. The comments of Srichander Ramaswamy, author of the BIS paper, are particularly interesting in this regard. Could large-scale redemption pressures on an ETF ignite a wider financial crisis? We’ll return to this topic next week.