A Game-Changer

Last Updated: 2 June 2023

It’s unlikely things can go on as before after this week’s flurry of warnings on ETFs

Conscious that I’m stepping into what is likely to be a brief hiatus between this week’s salvo of ETF-related warnings from the G20 Financial Stability Board, the IMF and the Bank for International Settlements, and a likely counterblast of official responses from ETF issuers, here are some initial thoughts.

My first impression is that this week will go down in history as having changed the way in which the ETF industry operates. It’s unlikely that things can go on as before, with a growing number of increasingly disparate fund (and non-fund) structures all being labelled with the same brand name.  How this is all resolved is anyone’s guess, but an obvious conclusion is that the ETF issuer’s own good name is going to be even more important than before. Trust in the issuer will override belief in the product concept. The industry has been surfing on a wave of pro-ETF sentiment for too long, perhaps.

Second, the ETF market’s growth rate will slow, and could even pause or go into reverse. The focus in the BIS paper on regulatory arbitrage by banks—the use of ETFs as a funding mechanism for parent investment banks, with the maturity of the swap being used to disguise the fact that the bank is effectively receiving overnight funding from the ETF while also obtaining relief from key liquidity metrics for the calculation of bank capital requirements—raises serious questions about the whole business model of synthetic ETF replication.

A regulatory tightening in this area could make synthetic replication uneconomic, while even the maintenance of the status quo may make it difficult for synthetic ETF issuers to expand their operations (i.e., for banks to assign much more balance sheet usage for the writing of ETF-related swaps). And, without doubt, after this week’s flurry of ETF-related questions, plenty more risk managers and compliance departments are going to be asking questions about ETF structures—and, I’m guessing, not just at buy-side firms, but within issuers’ parent companies as well.

Third, the physical versus synthetic replication debate has been reignited (perhaps, more broadly, one should speak of the battle between those ETF issuers that come from a fund management background and those that are part of investment banks). iShares is the leading exponent of the physical replication model, while Lyxor and db x-trackers are the leading firms in the synthetic category. In addition, there are now also several hybrids combining elements of both business models (Credit Suisse, for example, and HSBC to a lesser extent).

It was noticeable that iShares was quickest off the mark in responding to the first policy statement this week, that of the FSB on Tuesday. Within 24 hours iShares had put out a press release, arguing that the FSB had hit the nail on the head by pointing out potential conflicts of interest where swap-based ETFs and their derivative trading counterparts are within the same bank. iShares also applauded the FSB’s highlighting of the risks that arise if a bank uses synthetic ETFs as an inexpensive source of funding for illiquid securities.

But did the FSB thereby give the green light for the physical replication model, as iShares implies? Hardly. According to the FSB paper’s authors: “Securities lending…may create similar counterparty and collateral risks to [those incurred by] synthetic ETFs. In addition, securities lending could make the liquidity position of the ETF fragile, by challenging the ability of ETF providers to meet unexpected liquidity demands from investors, particularly if outflows from ETFs become significant under severe stress. A prevalence of securities lending could create a risk of a market squeeze in the underlying securities if ETF providers recalled on-loan securities on a large scale in order to meet redemptions. In addition, the use of ETFs as collateral in a long chain of secured lending and rehypothecation may create operational risks and contribute to the build up of leverage.”

That’s unequivocal. Meanwhile, the claim made by iShares’ European boss, Joe Linhares, in  Wednesday’s press release, that the firm “has always been transparent about the revenues generated and the risk framework surrounding its [securities lending] activity” is stretching reality.

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.

  • Luke Handt

    Hello, my name is Luke Handt; I am a successful Bitcoin trader, financial analyst, and researcher. I have been studying the market trends for the conventional stock exchange system globally since I was in college.

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