Hong Kong’s recently introduced rules on ETF collateral have drawn attention to the two different approaches used for synthetic ETFs in the territory. As we previously reported, the Securities and Futures Commission has ruled that domestic synthetic ETFs must have 100 percent collateral against counterparty exposure. Prior to this, providers were restricted to 10 percent net exposure per counterparty.
The majority of funds affected by the change are products that track the mainland China A share markets. Due to restrictions on foreign holdings of A shares, the ETFs can’t hold these directly and instead must purchase derivatives—usually known as China A share Access Products (CAAPs)—from institutions that have a quota to invest in A shares.
With A share quotas in limited supply, this means that the larger A share ETFs need to secure quotas from multiple sources. The iShares FTSE A50, the largest of the lot, currently has 12 counterparties. With many of these accounting for less than 10 percent of gross exposure each, the ETF needed to demand relatively little collateral under the old rules. Towards the end of August less than 30 percent of its exposure was collateralised.
Moving to a fully collateralised basis will push up costs, since counterparties will want higher fees to compensate. Indeed, iShares says that the cost of topping up collateral for its A share funds will be in the region of 50-100 basis points of each fund’s NAV, depending on the current level of collateralisation. BOCI-Prudential, which runs the second-largest fund and was around 70 percent collateralised before the rules changed, says it will cost around 40 basis points more.
However, there is a second type of synthetic ETF in Hong Kong, which will not be affected by the new rules. Cross-listed funds are exempt: these are mostly from European providers db x-trackers and Lyxor, which, due to being UCITS III ETFs, already needed to have at least 90 percent of net exposure collateralised. This technically means that domestic ETFs are now held to a higher standard than the UCITS cross-listed funds, although in practice the db x-trackers and Lyxor funds are overcollaterised.
Lyxor has no A share products at present, but the db x-trackers range includes a number of A share trackers. And the difference in costs between these and their Hong Kong-based A share peers is significant.
Most A share funds already carry very high TERs for ETFs—1.39 percent is standard, with a few around 1 percent. These will now rise due to the cost of holding extra collateral—either directly in the TER or through the tracking difference. IShares says that under its products’ current terms, these new costs will not be added to the TER although it is consulting investors on ways to make the added costs clear, possibly by amending the TER definition.
The db x-trackers products have TERs of 0.5 percent across the line-up, and these will be unaffected by the new rules. So could—and should—the presence of a lower-fee option limit the ability of other providers to fully pass on their increased costs?
Db x-trackers has a cost advantage in that they have a major bank behind them and don’t need to make use of a multi-counterparty CAAP structure within their funds. Instead, they have a swap agreement with Deutsche Bank, which the bank can lay off as it chooses.
But the SFC-regulated ETFs can make a case that the approach used in their funds justifies the higher fees. One argument is that the separation between fund manager and counterparty reduces potential conflicts of interest. For example, some investors may feel that swap pricing and costs will be more transparent when the two counterparties are not related.