A Confusing Debate

I was alerted to a recent Reuters survey on synthetic ETFs through a posting on the Securities Lending Traders Network group on LinkedIn. Someone posted up the story and there were several follow-on comments that I felt compelled to respond to. Rather than do that for just the group members, I thought I would share it in a blog as well.

The Reuters survey typifies the range of comments that are being thrown into the debate on ETFs. The June 14 headline was “Advisors warn against synthetic ETFs—Reuters poll”, with the subtitle describing British financial advisors as boycotting swap-based ETFs.

The first comment in the article doesn’t differentiate between swap-backed and replicating ETFs; it simply says that ETFs are geared to “burn and churn” traders. Best he sticks to equities then, where high frequency/algorithmic traders only account for between 40-55 percent of turnover on many markets.

The meteoric growth of ETFs also throws into question who exactly is boycotting ETFs and makes me wonder who was polled.

The rest of the article adds nicely to the misinformation/disinformation/confusion surrounding the subject matter. A good example of this is:

“Advisors say buyers must beware they could be buying ETF shares from a short-seller, meaning they may not have a claim on the underlying assets they want to be tracking but a promise to deliver the ETF share when the short-seller covers its position.”

I’ve read that sentence at least eight times and I’m still not certain what it says. To be clear, if you buy an ETF and it settles, then you own it and that represents your interest in the fund. It makes no difference whether you have purchased the ETF from a short-seller or a “long” seller and you have no further involvement with the short-seller covering his/her position (or not as the case may be). If it is talking about failed trades, that’s a different issue and you can read an interesting story by Paul Amery recently here.

I have been doing a lot of work on the structural risks of ETFs and want to take a moment to address counterparty risk and collateral risk as they relate to synthetic versus replicating ETFs. The reality is that the majority of ETFs carry risk in both areas, the only difference being the degree of transparency and whether the risks are incurred at the “front-end” or “back-end”. As a general comment, both types have substantial risk mitigants, so these exposures are well monitored and controlled and are in line with the trillions of dollars in the wider securities lending and total return swaps markets.

I haven’t been as aggressively outspoken on increased collateral transparency as others. My reasoning is that anyone outside of the professional marketplace doesn’t have the knowledge or experience to assess this type of market risk appropriately. The majority of institutional and retail investors aren’t in a position to understand the relevant risks. That’s not me being arrogant (although many will no doubt think that)—it’s just a fact. I’ve been through several defaults across my three decades in the business and have been involved in liquidation processes. Collateral is only worth the value you can recover in a default—ratings are less valuable than liquidity and collateral correlation is better as a theory than it is as a practice.

An example where the debate becomes misinformed is the furore over mismatched collateral. Many point to synthetic ETFs that might track an index yet hold collateral that has no correlation to that index. Instead it relies on over-collateralisation and the credit strength of the swap provider for protection. Guess what—it is commonplace in securities lending transactions that the collateral does not bear direct correlation to the assets on loan. Securities lenders rely on over-collateralisation and the credit strength of the borrower—sound familiar? Securities lending proved the resilience of its risk mitigants through the Lehman default.

The chart below summarises some of the key counterparty and market risk issues.

	Counterparty	Collateral
Replicating	* Where ETFs lend, they carry counterparty exposure * Most, but not all ETFs lend securities * Seldom publicly disclosed, specific exposure is usually not disclosed * Even when identity is disclosed, specific exposure is usually not disclosed	* Securities lending collateral— usually at 102-110 percent * May have regulatory restrictions (i.e. UCITS collateral rules) * Collateral held by specific funds infrequently disclosed, if at all
Swap-backed	* Swap counterparties disclosed up-front * Swap exposure usually disclosed	* Owner or pledge-holder of collateral (varies—check fund specifics) * Collateral usually disclosed daily * Typically over-collateralised and can be up to 120 percent for some ETFs * May have regulatory restrictions (i.e. UCITS collateral rules)

 

There are indeed differences between synthetic and replicating ETFs. Synthetics, less common and generally less understood, are at least more transparent as to counterparty exposure and collateral holdings. Neither is necessarily inherently risky and the scale of the ETF activity is a small subset of the larger businesses they are a part of.

The bottom line is that risks exist in all investments generally. Investors need to understand the risks in each investment and structure. I can’t comment here about any specific structure and each individual provider has its own products, structures, disclosure levels and practices. As a consultant of course I do risk assessment work on the topic.

I agree there is a risk that investors could be getting something different from what they are buying, and as some ETFs diverge significantly from plain vanilla funds that risk increases. But the lack of clarity and confusion doesn’t reduce the risk; it takes people down side alleys instead.

PS The Wall Street Journal printed a very good article on ETFs and securities lending last Wednesday. I agree with almost everything in the story.