Put The Cat Back In The Bag

Last Updated: 18 January 2023

A recent online survey of independent financial advisers (IFAs) in the UK found that 60 percent would not recommend a swap-based ETF. The feedback given by respondents suggested that this was in response to various regulators and other pan-European institutions asking some very pointed questions about ETFs—especially the derivative-based (or “synthetic”) variants of these increasingly high-profile vehicles.

This is a worry, as almost all European ETFs are constituted and regulated as UCITS funds, and UCITS are supposed to be a product for the average man or woman on the average European street.

The issue of counterparty risk associated with swaps is the core concern of both IFAs and the regulators. IFAs will remember that the UK regulator issued some very strong words (and fines) when counterparty risk was last raised in connection with “guaranteed” or “structured” products.

Collateral or collateral?

Possibly nudged on by active managers, who are keen to see low-cost ETFs get “a good kicking”, the regulators then started asking tricky questions about securities lending too. Is the economic exposure created by securities lending the same as in swap-based ETFs using reference baskets? Both have collateral posted, and this collateral may differ in quality and behaviour to the index being tracked.

The securities lending lobby will point to governance requirements such as the standards set by the FSA in the UK, where market participants have drawn up the Securities Borrowing and Lending Code of Guidance (2009). It was issued by the Securities Lending and Repo Committee, a committee that is chaired and administered by the Bank of England and is observed as a guide to good practice.

Additionally, the Global Master Securities Lending Agreement (GMSLA) is a best practice agreement drafted by the International Securities Lending Association (ISLA), which is used by many participants.

The swap-based fan club will refer to the fact that collateral held to offset derivatives exposure must comply with Committee of European Securities Regulators guidelines (CESR/10-788). It is also true that an increasing number of synthetic issuers allow you to see the basket holdings and exposure daily, whereas with securities lending there is no equivalent disclosure.

The regulators should be encouraged that all ETF players have responded so quickly with greater transparency, even if the players don’t all agree on whether physical or derivative-based structures are best.

For most retail advisers, however, the key point remains that it is difficult to explain to consumers why a FTSE 100 tracker, for example, may hold a reference basket of Japanese equities or Greek Debt and a swap—even though UCITS rules set some minimum requirements to the reference basket assets (for example, concentration limits and permissible holdings).

Another concern is that swap-based ETF providers suggest that the possible loss resulting from counterparty exposure is limited to 10 percent (the level at which the exposure to a counterparty under a swap is subject to a “reset”), when in fact the losses could be higher in the event of a default by the swap provider (as a result of “gap risk”, a shortfall when collateral assets are sold or as the result of a delay in gaining access to collateral).

There will be concerns over the collateral received by funds in securities lending operations even though this typically exceeds the value of stock or bonds lent and there are limits on the amount of the fund lent. Some lending agents provide indemnification to the fund, but further disclosure in this area would be welcomed by professional investors. What is the exposure to each borrower, for example?

The expectation of collateral is that it will be there, in sufficient quantity and in liquid form, when you most need it. This may not always be the case.

But the risk is everywhere

The regulatory spotlight has so far only been shone on ETFs. But there are many other occasions when retail investors might be exposed to swaps, derivatives or lending risks.

We can compare index mutual funds for starters—there is a similar level of securities lending risk here—yet do index funds have the same level of disclosure as, for example, iShares ETFs?

Where else might large scale securities lending be taking place? Active funds? Life funds? Insurance based pension funds? Yes to all of those. Is the process and collateralisation transparent? And is the fee share disclosed?

Where swaps and other derivatives are involved, what is the level of disclosure of risk within non-index UCITS funds? And what about life funds—do they not often use OTC derivatives to protect solvency? Are these well collateralised, well priced and transparent? Who knows?

Don’t be ridiculous, you might say. Of course we can’t have full disclosure of every derivative instrument in a UCITS or any other retail fund. But the issue is that investors are supposed to be reassured when a fund is compliant with the UCITS rules and, in my opinion, these rules have been flexed to allow inappropriate and complicated structures such as synthetic ETFs with mismatched reference baskets inside the regime.

What next?

The UCITS regime was originally intended to create simple, diversified products that could be sold in high streets across Europe. UCITS III and IV have introduced levels of complexity that didn’t exist before. While the objective may be to reduce risk, that will only be achieved if there is a clear and honest demonstration of aligned interests, together with a full disclosure of costs, revenues and counterparties, that the man or woman in the high street can trust. Anything less increases the risk to one of the greatest ever investment brands, UCITS.


  • 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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