Collateral Battles

According to Edouard Vieillefond, deputy secretary general of France’s securities regulator, the AMF, the public battles between providers of physical and synthetic exchange-traded funds come down to a single main issue: how both types of issuer provide backing for their funds’ holdings.

“The risks involved in those physical ETFs that lend stocks and in synthetic ETFs are similar,” said Vieillefond in a telephone interview with “In both cases the collateral is ultimately what guarantees that the investor gets repaid in the case of a counterparty failure. So everything boils down to collateral and collateral policy.”

“Understandably, there’s a dispute between providers of different types of ETFs over business models,” added Vieillefond. “We’re keen that the technical debate on regulatory standards shouldn’t become polluted by this tough exchange of views between different ETF companies, or influenced in any way by their private interests.”

Vieillefond expressed satisfaction that regulators’ interventions have prompted greater disclosures about fund structure amongst ETF issuers.

“We’re happy that ETF providers are now offering greater levels of transparency over their collateral policies. One of the objectives of the G20 Financial Stability Board report on ETFs that came out earlier this year was to trigger such a reaction.”

Since 2010, most European issuers of synthetic ETFs have started to publish details of their funds’ “substitute baskets” or collateral holdings, including the extent to which derivatives-related fund exposures are backed and the individual securities used for the backing (although terminology in Europe’s ETF market is not standardised, issuers of synthetic funds using unfunded swaps tend to refer to their funds’ substitute “assets” or “basket”, while those using funded swaps use the term “collateral”, with such collateral being pledged or transferred to the fund by the derivatives counterparty).

iShares, Europe’s largest issuer of physically backed ETFs, is now also publishing details of the collateral held on behalf of those of its funds that lend securities, although the firm doesn’t disclose what proportion of each fund is are being lent out, nor the names of individual counterparties.

But in addition to ensuring investor protection, collateral policies have a direct impact on financial institutions’ profitability. The economic incentives underlying derivatives transactions and securities lending policies were highlighted in the response by ETF issuer Lyxor to the recent discussion paper from the European Securities and Markets Authority (ESMA) on UCITS ETFs and structured UCITS.

“All [UCITS] structures, whether ‘physical’ or ‘synthetic’, wish to benefit from the difference in repo rates between the asset they own, directly or as collateral, and the assets [to] which they are exposed,” argued Lyxor in its submission, explaining its view that there is little underlying difference between the two types of ETF.

The repo rates Lyxor refers to are the cost (expressed as an interest rate) of raising secured finance against a basket of securities. In a synthetic ETF any difference between the repo rate on the substitute or collateral basket held by the fund and the repo rate on the index securities represents an additional source of income for the issuer. In a physical ETF a similar interest margin is earned, but in a transaction that is effectively a mirror image of that undertaken by a synthetic ETF: index securities are lent out by the physical ETF, generating interest income, being replaced temporarily by other securities that have a lower lending value. In both structures, fund managers typically retain a proportion of the additional earnings generated.

iShares has taken a diametrically opposing view to Lyxor (and to other synthetic ETF providers who have expressed similar views), arguing in a recent document “ETP Due Diligence” that the two ETF categories—physical and synthetic—are fundamentally different. While it said that physically replicating ETFs are “simple and easy to understand”, “transparent regarding costs and underlying fund holdings” and have “no or limited counterparty risk in the case of securities lending”, what iShares called “derivatives replicating ETFs” (i.e., synthetic funds) “differ significantly from physically replicating ETFs in terms of risk and complexity”.

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