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 [1] (FSB), The International Monetary Fund [2](IMF), and the Bank for International Settlements [3] (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 [4] 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 [5] (also known as swap-based ETFs) in this article, and deal with physical ETFs later.
[6]
Emerging synthetic ETF risks
It’s the runaway success of ETFs that requires the risks to be reassessed. The ETF dream [7] 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 [8] 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 [9]. Instead they buy a total return swap [10] 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 [11], 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