You Can’t Choose Your Parents

The weakness in banks’ financial positions must be exercising ETF issuers’ minds.State Street shares plummeted 59% on Tuesday after a big loss was announced, together with a poor profit outlook. Barclays shares have now fallen the same amount since the beginning of 2009, and 86% over the last 12 months. Deutsche Bank shares are down 78% over a year, and Société Générale’s shares 65%.

The relevance of the last three names is of course that they are the parent companies of Europe’s largest ETF providers—iShares (Barclays), Lyxor (Soc Gen) and db x-trackers (Deutsche Bank).

Here, for reference, and courtesy of CMA DataVision, is a chart of the 5 year credit default swap spreads for the senior debt of the three banks since the beginning of last year. The left-hand axis gives the CDS spread in basis points per annum.  All three have seen a big rise in the cost of default insurance, even if current levels are below those of last October, when governments intervened worldwide with rescue packages.

But do ETF investors have anything to worry about from the latest bout of turbulence?

On the face of it—no. ETFs are structured as segregated funds, whose securities are held at separate custodian banks, distinct from any assets owned by the ETF issuer itself. In the case of the parent bank’s insolvency, the ETF-owned assets should be ring-fenced and bank creditors should have no recourse to them.

ETNs are of course different—they bear the full credit risk of the issuing bank, and in a bankruptcy, owners of ETNs would have to line up with other creditors in the courts. If a bankruptcy loomed, you certainly wouldn’t want to be holding that issuer’s ETN.

But is this the full story? An investor specialising in ETFs told me the other day that, in general, he is comfortable with the risks that bank insolvency might present. Nevertheless, he said, there are three areas that might present some possibility for complications, should the worst come to the worst and an ETF parent bank failed.

First, in the case of a swap-based ETF, there is the mismatch risk between the index being tracked and the assets being held as collateral for the fund. An investor might end up with a wholly-unexpected pool of assets, which might be more or less difficult to liquidate at a reasonable cost.

Second, the provider of a swap for a swap-based ETF might fail. A UCITS-compliant ETF should have mark-to-market swap exposure that does not exceed 10% of the value of the fund and, as a recent survey on www.indexuniverse.eu showed, ETF providers typically manage this risk to a lower percentage. Nevertheless, the failure of a swap provider would be extremely messy.

Third—and this is a highly technical legal area on which I’d like to get further clarification—there may be a risk of cross-class contamination in ETFs structured as umbrella funds (which represent many European ETFs). While this may be more of a risk for inverse and leveraged ETFs, it could affect other, more traditional funds as well.

Putting these risks into context, ETFs still remain a relatively safe investment vehicle by comparison with many other types of structured products or debt obligations. Recent inflows into the ETF sector are testament to this.

But the possibility of a parent company bankruptcy, something totally improbable a year ago, must now be examined seriously by issuers in their contingency plans.

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