Credit And Counterparty Risk

Well, I picked a momentous couple of weeks to be on holiday! Having finally (more or less) caught up with the events of a fortnight that encompassed the bankruptcy of Lehman Brothers and the default on its ETNs (exchange-traded notes); the last-minute rescue of AIG by the US taxpayer; the suspension of trading in several ETCs (exchange-traded commodities); the near-failure of HBOS in the UK; violent swings in equities, global currencies and commodities; the extension of short-selling restrictions; and now another attempt by the US government to stabilise the financial system through a massive bailout package, I am still pondering the likely fallout for the ETF market and its cousins, the ETC and ETN markets.

Here are some thoughts, falling into three categories.

The credit risk concerns that have been bubbling away all year came to a violent eruption on September 15 with the Chapter 11 filing of Lehman Brothers, followed a day later by the near-failure of AIG and an emergency $85 billion loan from the Federal Reserve to save the insurer. As always, the counterparty risk picture is best illustrated by the CDR index,* which shows the average CDS (credit default swap) spreads of 15 leading dealers.

The most recent spike showed the index rising almost threefold in a matter of days and, while the index has retreated from its highs, it is still well above the levels of the March Bear Stearns peak. Meanwhile, a recent report showed Lehman’s senior unsecured debt trading at 18% of par value after the bankruptcy filing, indicating that investors in Lehman’s OPTA ETNs have lost nearly all their money. Even if I am among the more pessimistic of my IndexUniverse colleagues, I find it hard to see how the ETN market can regain investors’ confidence and recover from this shock.

Meanwhile, the people at ETF Securities and many of their investors have no doubt endured a few sleepless nights over the last two weeks, as market-makers either stopped quoting prices for the AIG-backed ETCs when the US insurer faced collapse, or dropped their quotes dramatically—while, unbelievably, AIG was still rated AAA by Standard & Poor’s right to the brink. And if trading in the relevant ETCs has now restarted and investors seem to be able to emerge whole from the debacle, this is due more to luck than judgment—and hearty thanks are due to the US taxpayer, who is involuntarily underwriting AIG’s solvency to the tune of $85 billion.

So on the counterparty risk front, the real question is not so much whether the ETN market will survive (probably not, in my opinion) or how the ETC market will continue (no doubt with some radical changes to the structure of some of the securities), but to what extent the whole exchange-traded securities market is going to be affected, and how it can continue with such a broad range of underlying credit exposures, confusing many investors. Recent events have highlighted brutally that an in-specie ETF and an ETN (to give two examples) have little more in common than the first two letters of their name.

In Europe, I can count at least five different exchange-traded securities with varying exposures to credit risk: in specie ETFs, swap-based ETFs, bullion ETCs, swap-based ETCs and ETNs. Product providers have in general done a poor job in explaining the differences to investors and this undoubtedly has got to change—otherwise they are likely to shy away from the better products as well as the not-so-good.

Two areas where transparency is still lacking for ETF investors are the collateral policies used by swap-based ETFs, and the collateral management policy used in stock lending. If you own a money market ETF, do you know and should you care that the collateral backing the swap is a basket of Japanese equities (to give a hypothetical example, but one which apparently reflects recent market practice)? And what are the guidelines followed when an ETF’s underlying holdings are lent out—how safe is the collateral, and are there indemnities in place to protect the investor’s interest?

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