The sleepy backwater of passive investing has been rudely disturbed by the clanging of alarm bells. The explosive growth in Exchange Traded Funds (ETFs), especially synthetic ETFs, has been spotlighted as a potential threat to the stability of the global financial system in reports by the G20’s Financial Stability Board (FSB), The International Monetary Fund (IMF), and the Bank for International Settlements (BIS).
The reports warn of a daisy-chain of risks embedded in the design and operation of ETFs. They urge investors, regulators and the ETF industry to take heed.
Having read a flurry of disturbing media articles based on the reports, I dived into the original material hoping to discover the threat had been hyped out of all proportion. Unfortunately not. The FSB talk of “disquieting developments” and the BIS paper draws upon the experience of the sub-prime implosion to warn of the dangers of looking the other way.
There’s a lot to take in, so I will concentrate purely on the potential threats posed by synthetic ETFs (also known as swap-based ETFs) in this article, and deal with physical ETFs later.
Emerging synthetic ETF risks
It’s the runaway success of ETFs that requires the risks to be reassessed. The ETF dream is access to a diversified low-cost portfolio using a simple investment vehicle that can be traded like shares. That’s jacked up global ETF assets under management from $410 billion in 2005 to $1,310 billion in 2010, according to the BIS.
But this rapid rise has fostered innovations like synthetic ETFs that could have unforeseen impacts during times of market turmoil. The reports highlight a number of possible dangers that feed into each other, including:
- Counterparty risk
- Collateral risk
- Liquidity risk
- Conflicts of interest
Counterparty risk
The most famous example of a counterparty default is Lehman Brothers. In the ETF world, counterparties are most commonly used by synthetic ETFs. Unlike physical ETFs, synthetics don’t use their investors cash to buy the physical underlying assets of the index they track. Instead they buy a total return swap from a counterparty (usually an investment bank) that guarantees to pay the ETF provider the return on the index being tracked.
If the counterparty goes bust then there’s nobody to pay the ETF return. That’s unpleasant but supposedly not disastrous because the counterparty hands over collateral to the ETF that’s meant to cover at least 90% of the ETF’s assets. In an emergency, the ETF provider can sell off the collateral to repay investors.
It’s conflict of interest time again
Unfortunately, all three reports identify potential conflicts of interest in the structure of many synthetic ETFs, to the extent that I’m reminded of playing Jenga on a wobbly kitchen table – in Tokyo.
The problem is that ETF providers and counterparties are often different arms of the same institution – especially in Europe. For example, Db x-tracker ETFs are part of Deutsche Bank and Lyxor ETFs are a chip off the French bank, Société Générale.
The suggestion is that investment banks can save costs in other parts of their business by using ETF collateral baskets as a dumping ground for illiquid, hard-to-sell securities that might otherwise be cluttering up their books. For example, your FTSE 100 ETF might actually be backed by unrated corporate bonds or Japanese small caps.
The FSB suggests that lowering the cost of funding may be the reason why investment banks conjured up synthetic ETFs in the first place:
As there is no requirement for the collateral composition to match the assets of the tracked index, the synthetic ETF creation process may be driven by the possibility for the bank to raise funding against an illiquid portfolio that cannot otherwise be financed in the repo market.
And while that may be good for the banks, it’s not so great for investors in the event of a market crisis.
Collateral risk
Though synthetic ETF assets and investor interests are theoretically covered by collateral, all is not rosy:
- Illiquid collateral is hard to shift. This could damage the liquidity of ETFs that are forced to sell in order to meet redemptions.
- The collateral may not adequately cover the ETF’s assets, especially in a falling market.
- The ETF may not be able to sell pledged collateral, if it is frozen by a bankruptcy administrator when a counterparty fails.
ETFs often maintain collateral worth up to 120% of assets, but as the BIS comments:
Overcollateralisation might provide little comfort, as crisis experience has shown that collateral quality tests and collateral coverage tests designed by rating agencies for structured products did not protect senior tranche holders from losses.
If collateral provides cold comfort and seismic market events heighten the possibility of counterparty default then nervous investors could force a run on synthetic ETFs, as outlined by the BIS:
Patterns of withdrawal from money market funds during the crisis show that institutional investors are likely to be the first to run when markets question the solvency of a fund provider, which can then trigger a broader run on the industry.
Liquidity risk
If the ETF provider faces a tidal wave of redemptions requiring cash to be returned to investors, then a mechanism that has previously been a font of cheap funding could become a strain, in the view of the BIS:
Sudden and large investor withdrawals triggered by market events or counterparty risk concerns can also lead to funding liquidity risk. This risk can propagate through the investment banking function, which might take for granted the access to cheap funding through the swap arrangement with the ETF sponsor.
The evaporation of funds, compounded by congealing collateral, could also compromise the ETF provider’s ability to maintain the market liquidity of synthetic ETFs, according to the FSB:
In case of unexpected liquidity demand from ETF investors, the provider might face difficulties liquidating the collateral and may be faced with the difficult choice of either suspending redemptions or maintaining them and facing a liquidity shortfall at the bank level.
Funding stress at the bank – in the teeth of extreme market conditions – would surely heighten fears of counterparty risk. As the FSB puts it:
Since the swap counterparty is typically the bank also acting as ETF provider, investors may be exposed if the bank defaults. Therefore, problems at those banks that are most active in swap-based ETFs may constitute a powerful source of contagion and systemic risk.
Moreover, the other option of suspending redemptions could have knock on effects for the market-makers who match buyers with sellers on the exchange, adding to the turmoil. The BIS paints the picture:
Because ETF redemptions will require cash to be delivered against collateral assets that might be illiquid, market-making activities could be severely hampered, as funding these assets might take priority. The collapse of funding for individual financial intermediaries could then reinforce funding stresses for the financial system as a whole.
Run for the hills?
Added together it’s enough to make my primal-self want to split my money between the mattress and a hole in the ground. However, all three reports are careful to point out that they’re highlighting potential risks, not an imminent doomsday scenario.
The ETF industry is already responding with talk of how robust their operations are and claiming that the theorised collision of calamities is the kind of black swan that won’t fly.
Still, few saw sub-prime coming either and no doubt that’s contributing to greater regulator vigilance this time.
There’s plenty more in the reports if you fancy a bigger dose of the willies. Warnings about the complexity of leveraged and inverse ETFs, the impact of ETFs and ETCs on their underlying markets… and there’s no need to look smug if you only hold physical ETFs. Security lending programmes leave them exposed to collateral and counterparty risk, too.
I’m not advocating consigning synthetic ETFs to a toxic tank that’s already full of endowment mortgages and split zeroes. We need to see how this one plays out.
But rest assured I’ll be keeping an eagle eye on synthetic ETF risks in the future.
Take it steady,
The Accumulator
Comments on this entry are closed.
1. Hi TA, really glad you’re looking into this. Like you, I’ve been reading those press stories – and the official responses from some of the UK ETF issuers.
2. Here there are clearly multiple issues.
3. Transparency is a key concern. However, it’s not as if the holdings of active funds are open and transparent. We in the UK often only know their top-10 holdings – and on a retrospective basis. Further, what about so called ‘absolute return’ funds?
and why stop with synthetic ETFs, counterparty risk is rife in more places 😉
For example I hold IBZL in an iii S&S ISA account. it is my belief that IBZL is a real Ishares ETF, as in they hold real shares from the Brazilian market, leatsways that is how I read the key facts doc. No problems then?
Say Ishares also issue some synthetic ETFs, and these succumb. Say the amount is such that Ishares decide bankruptcy is a good way to go. Now the creditors press their case on ishares – I get to share a slice in the pain as I am just one of the many creditors, even though I took care to only hold nominally ‘real’ ETFs
The same counterparty risk sort of goes for iii as well, say they go bust then I get to take a haircut too.
So the lesson seems to be diversify ETF providers, and perhaps diversify ISA providers too…
Diversify *everything* in my view. 🙂
There are no certainties, but I have never felt comfortable with ETFs as there are simply more components in the mechanism. Trouble is, if ETFs do blow up, so will everything else. Always keep some cash and don’t whinge.
Good article, thank you.
I guess with the rise of a new product (from $410 billion in 2005 to $1,310 billion in 2010 as you pointed out) there was always bound to be this sort of risk.
@ermine – re holding shares via a fund platform such as iii, I’m sure I’ve read somewhere that if a fund platform goes bust it won’t force a haircut on anyone as it is merely a platform for purchasing investments, rather than the investments (or counterparties) themselves.
Therefore, if iii/H&L/whoever went bust, it would be an inconvenience, but wouldn’t affect investors monetarily.
I’m happy to be corrected if I’m wrong though?
Also, I was at a conference recently and managed to interview one of the Basel Committee – I think they have a handle on this for the upcoming regulatory changes.
This will be especially true for EFT providers like Dbx (Deutsche Bank), Lyxor (SocGen) and Ishares (which I believe is Barclays) as banks like this will be the focus of the Basel Committee to lead the way in holding the advanced levels of capital necessary under new regulations to cover times when fancy new financial products go horribly wrong.
The biggest problem I can see is being with US banks – they have only just begun implementing the old round of Basel regulations and will presumably be equally slow in implementing the upcoming regulations.
Therefore, with their potentially risky products such as synthetic ETFs, they won’t have the same capital reserves the bail themselves out if it all goes belly-up.
As a side note, I was speaking to a hotshot banker at a do recently and he was trying to convince me that credit default swaps (one of the riskiest products a bank does and a massive component in the global recession) is as risk-free as a +AAA rated government bond – I think this goes to show that no matter how much regulation there is, some bankers will find a way to burn the system down.
Sorry for the wall of text – I tried to keep it relevant. 🙂
@Michael – Having, like many other stalwarts of this parish, both an ii S&S account and a less-than-fully trusting approach to the financial services industry, I phoned ii earlier this year to ask what would happen to my investments should things go badly at ii. Here’s the meat of their written reply :
Halifax Share Dealing (HSDL), as part of Lloyds Banking Group, administer the share dealing service of Interactive Investor. Lloyds is the UK’s biggest savings and mortgage provider which has a strong capital base and as such you can be confident that you are dealing with a sound business. The stock you hold with II via HSDL is held in a nominee company which ensures that it is appropriately segregated from the assets of the company. This means that your assets will at all times be clearly identifiable as belonging to a customer and not to HSDL. Similarly, cash is held in separate client bank accounts and is segregated from HSDL’s assets. In the unlikely event [ha! now we come to it ..] that these segregated assets were unavailable for distribution and HSDL were unable to meet claims made against it, all eligible customers would be able to make a claim on the Financial Services Compensation Scheme up to a maximum limit of £50,000.
@ Tyro – thanks for that. I’ve looked under similar rocks and discovered the same. It’s hard to get an answer that lets you sleep easy when it comes to financial services.
Such uncertainties only confirm the wisdom of Ermine, Salis and The Investor – trust no-one, diversify everything.
@ Michael – The reports do mention that local regulators are homing in on these issues, but then the pin-stripes always seem one step ahead. US bank exposure to synthetics is a fraction of Europe’s. Regulatory differences mean physical ETFs held the whip hand in the US, and the SEC have put a stop on development of new synthetics since January while they review the situation.
@ Ermine – what do iShares say about how your physical ETF is segregated (or not) from the liabilities of their other funds?
As you say, counterparty risk is ubiquitous, although most of what’s written about ETFs suggests it’s only a problem for the synthetics. What bothered me most in the reports was the potential for the problems to resonate and amplify one another. So nervousness about collateral and the ulterior motives of multi-armed financial entities offering synthetic ETFs, exacerbates counterparty risk as investor panic becomes a self-fulfilling prophecy.
Truth is, we don’t know where the next bomb will go off, but at least someone’s looking for it.
As a newbie halfway through implementing a Global Style Tilts 4 Portfolio, I was about to acquire my first ETF when I read this and chickened out.
This site/blog is fascinating and has taught me much of what little I know… I think I’ll need more of these helpful articles before I can gauge the trade-off between diversification and this ETF risk.
@Tyro – thanks for checking up there. I was unaware that FSCS applies to investment platforms, and I can’t quite see how the £50k maximum is applies to a S&S ISA – is that the valuation when HSDL goes down, presumably such an event would coincide with a stock market meltodown and the inability to sell (or buy, for those with the intestinal fortitude) would impact the portfolio value.
@TA, from the MoU/ Articles of Association of iShares on page 17
which looks good, but it all turns on what ‘save as provided in the Acts’ means in the hands of an expensive lawyer. It’s this sort of thing that gave me the willies about holding precious metals as EFTS ETCs – in the situation where gold is the last man standing you can trust nobody. The situation with ETFs is better, inasmuch as the financial circumstances under which Ishares goes down are going to be close enough to finacial Armageddon that it is possible that the value of what you lose isn’t going to be worth that much anyway.
There has to be space in the marketplace for a basic ETF honest broker that just does ETFs backed by real shares. But then their charges will be a little more, because some of the finacial chicanery in swaps etc could be used by other providers such as Ishares or hsbc to reduce the apparent TERs, and the usual theory of bad money driving out good will hold 😉 We punters are unwilling to pay extra for insurance/financial integrity until after we needed it, whereupon we kick up something rotten. It’s IceSave all over again…
Thanks Ermine, will have to try and track down these fabled acts. I always get the same sinking feeling when reading a prospectus, the sub-text of every clause seems to be: ‘Everything will be fine, until we say it’s not’.
iShares ETFs are mostly physical, but they’ve recently dabbled in synthetic, presumably tempted by the forces you allude to. Hopefully Vanguard will release their ETFs over here this year.
@ Michael – forgot to say earlier, iShares used to be Barclays, now Blackrock. Not to be confused with Blackwater.
@ TileStilt – which asset class did you want to cover with the ETF?
A few hours after posting I had a metaphorical stiff drink and did the deed:
iShares FTSE EPRA/NAREIT Developed Markets Property Yield Fund
db x-trackers Stoxx Global Select Dividend 100
Lyxor ETF Commodities CRB
Does this sound like Leonardo DiCaprio leaping aboard the Titanic just as it sails? If you have a better idea, I can always write off £40-60 of Alliance Trust buy/sell fees as a learning experience and swim back ashore…
No better ideas for those asset classes. I own the first two myself. The iShares ETF is physical and doesn’t engage in securities lending, so that one at least is off the hook. The way I see it is that I’m not over-exposed to these asset classes, there’s no other way to access them with trackers, there are plenty of other risks I could worry about aside a theorised doomsday scenario, so I’m not going to sweat it too much.
For property you could buy investment trusts or REITS that own their underlying property. The tracker invests in them of course, but at one remove. As TA says, I wouldn’t worry about non-synthetic ETFs much at all, but as your portfolio grows (well into six figures say) you might want to diversify into a couple of different vehicles with a chunk of it.
Of course you’ll be swapping a theoretical risk for other risks. With an IT that includes management risk, discount risk, gearing, and under performing against your benchmark! 😉
@ TA & TI Thanks, but it still feels rather frustrating that Tim Hale’s portfolios are so hard to implement. Considering his book’s gone to a 2nd edition with a 5-star rating from 17 reviews on Amazon, there must be some demand out there for decent relevant products.
I feel your pain. Providers seem far more concerned with pumping out ever more obscure sector ETFs with extra toppings (would you like an inverse leveraged fundamental index with that, sir?) than with offering a decent value product like wot the Americans have got.
Starting to get worried, had thought this issue had been over hyped but when you hear that DB is leveraged at 51 trillion(zero hedge.com),might be time to get out of their ETFs and anything to do with DB or Barclay’s for that matter.
@Steve — ZeroHedge is a comic. It has a passing relevance to investing in the same way the Batman movies offer passing insights into crime fighting.
Investor – I take your point about zerohedge however do you think that the amount of money leverage up against DB (who stand behind many ETF SWAP agreements) has heightened the risk since this article was first published. I don’t believe the 51 trillion is deniable as this has also been mentioned in the national press.
@Steve — Let’s say you and I go to the racetrack and you bet £100 on horse A and I bet £100 on horse B. There are no other horses and no other punters.
What’s the risk to the bookmaker in this scenario?
P.S. To spoil the suspense, the risk is one of us can’t pay. I.e. Counterparty risk. But the bets will generally net off. Same with derivatives.
There’s a risk but it’s much much less – and different – than the total exposure from the derivatives.