Clearing Questions

Since the credit crisis, regulators have been coming to grips with counterparty risk, or the notion that one party in a transaction might not honour its contractual obligations. Policymakers from the G20 countries, in particular, have been pushing for derivatives contracts to be settled through a central counterparty clearing system. This, it is hoped, will help reduce wider systemic risks in the financial market.

In a market worth over €200 billion, more than half of Europe’s exchange-traded funds use synthetic replication.  This means that their returns depend on an over-the-counter (privately negotiated, bilateral) derivative agreement with a counterparty, typically a bank. According to some lawyers and risk experts, the shift towards central counterparty clearing could hit the synthetic ETF industry by making it more expensive – or even impossible – to provide those derivatives at an economic level.

“We could get to the stage where a synthetic ETF will actually underperform the index it is tracking by more than the fund fees because of the extra collateral costs that central clearing might involve,” said Simon Gleeson, a specialist in financial regulation and derivatives at London law firm Clifford Chance. “And if that happened you could speculate as to whether there was in fact a future for that type of synthetic ETF.”

Synthetic (or swap-based) ETFs first appeared in Europe a decade ago, with the launch of a CAC 40 tracker by Lyxor, a subsidiary of French bank Société Générale. The idea was simple. Rather than buying the index securities itself, the issuer could outsource the responsibility for index tracking to a third party (the swap counterparty). The synthetic ETF was born.

In practice, since Europe’s UCITS fund rules allow a fund to have only limited naked exposure to derivatives, a swap-based ETF also buys a basket of securities, often from the same counterparty. Through the swap, the ETF exchanges the performance of the basket for the performance of the index the ETF is tracking. The securities contained in the basket often do not include any from the actual index being tracked, but are instead chosen by the bank to conform with certain regulatory limits.

Spurred on by the general flexibility of UCITS with regard to the use of derivatives, swap-based ETFs now outnumber ETFs using the more traditional method of physical replication. The providers of swap-based funds market them as a more efficient way to invest in certain indices, with the swap able to reduce the tracking error between the ETF and the underlying benchmark.

The swap-based ETF model has been refined since its 2001 creation – largely in response to concerns over counterparty risk resulting from the financial crisis and as a result of competition with physically backed ETFs. For instance, many synthetics now use non-affiliated banks for their swaps, as well as using multiple counterparties to diversify risk.

Still, synthetic ETFs are not without their critics. Last month, Fundsmith’s chief executive, Terry Smith, warned that ETF investors might be placing their faith and their money in products they do not fully understand.


“The idea that a counterparty will provide you with a contract which matches the returns from underlying illiquid assets which you cannot directly own should give pause for thought,” Smith wrote on his website, adding investors should think about “how the counterparty will fulfil those obligations, for example in the case of extreme market movement and a liquidity crisis — a not unlikely combination.”

There’s also the issue of securities lending. Most of the collateral held by or on behalf of synthetic ETFs is ring-fenced. However, some of it may be lent out to other firms or rehypothecated. “The swap desks do the securities lending,” said Deborah Fuhr, global head of ETF research and implementation strategy at BlackRock. This can help banks generate revenue to cover the costs of providing the ETF swap and can also help reduce expenses charged to the ETF’s investors.

However, it does potentially add another layer of counterparty risk to the transactions.

A push towards central clearing is aimed at averting exactly the kind of ripple effect seen in the financial system after Lehman Brothers’ fall – when billions of dollars worth of derivatives-related collateral was tied up in the bank’s bankruptcy — or the near-collapse of the giant insurance firm, AIG. It would involve derivatives being cleared and settled through central counterparties, or clearing houses.


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