Analysis: Industry voices fears over ETF counterparty risk perils

18 October 2011 | By Rodrigo Amaral

In a speech to the European Parliament he hinted that, owing to their complexity, the European Union might not be able to regulate synthetic ETFs any longer under its Ucits retail fund directives. That would prove an obstacle for providers of synthetic ETFs because it would keep these products out of the reach of many retail clients.

The European authorities are not the only ones to have expressed such concerns. Answering a consultation by the European Securities and Markets Authority, Fidelity, the fund management giant, said that some synthetic ETFs had no regard for the needs of retail investors. The company says it feels more comfortable working with providers that are independent of banks, a comment that touches on a problem that has been much discussed in the market of late: counterparty risk.

Several ETF providers are owned by large banking groups and use their parent companies’ resources to service their products. Synthetic ETFs use derivatives to replicate an index, mimicking the value reflected by its assets rather than owning the assets themselves. They can sign their derivative contracts with a separate division of their parent company - in other words, use them as the counterparty on their trades.

Supporters of such products argue these arrangements guarantee that investors have a good idea of the returns they will receive, as the swap counterparty promises to deliver a similar performance to the target index. Relevant counterparties post assets as collateral with a custodian bank. Their valuations must match or come close to matching the ETF’s assets. In some cases, the collateral is worth more than the promised return on the derivative, in a quest to satisfy safety-conscious investors.

But debates rage in the industry over whether having a single counterparty is riskier for investors than having several. The main doubts concern what happens if the company that owns the collateral gets into difficulties.

Michael John Lytle, the managing director of Source, a provider of ETFs that use multiple counterparties on their trades, says: “If you have five swap counterparties and one day decide that you don’t want to have exposure to one of them, it is quick and easy to take the balance that you have with it and spread it around the others. But if you have only one counterparty and don’t like it any more, you have to go through all the filing of documents and putting operational building blocks in place.”

A senior executive at an ETF provider owned by a bank, who spoke on condition of anonymity, says that, at the best managed houses, systems are in place to guarantee investors’ assets, even in the event of bankruptcy. Contracts are transferred to the fund and collateral is kept by custodians. When the arrangement is properly executed, the argument goes, the collateral is legally ring-fenced from the counterparty. The executive also says that, in multi-counterparty models, the distribution of collateral can be uneven, and some counterparties can end up answering for a disproportionate share of the assets. There is no guarantee that, if one counterparty goes bankrupt, others will step up to take its place. Another argument is that investors often don’t know how the funds’ assets have been spread around the counterparties, which might make the single counterparty model clearer.

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A concern over in-house products is that some ETF providers might accept the services of their parent companies without having the best interests of investors in mind. Lytle says investors must consider whether the terms of a fund’s derivative contracts suit their interests, particularly when a fund does not choose its counterparties from a field of competitors that vie for clients by offering lower rates and better service.

The senior executive says independent service providers can prevent counterparties posting illiquid collateral, an arrangement about which ­regulators have expressed reservations. According to some critics, ETFs that work with service providers from their parent company make life easier for fraudsters, who need to break the security standards of only one company instead of several of them.

For ETFs, the advantages of single and multiple counterparties are clear. But can all the players in the market handle them appropriately? The senior executive says that not everyone is following the same standards, which helps to explain some of the bad press surrounding synthetic ETFs in particular.

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