Something like $3,200bn flows through the FX market every day. That’s enough to whet the appetite of any financial service provider in terms of prospective flow action.
The exchange-traded fund community happens to be no stranger to such temptation. In fact, ETF issuers in the United States have been tapping into the market’s apparent growing need for cheap and easy exposure to foreign exchange for a number of years now.
It’s what you might term a meeting of the unregulated OTC forex market with the increasingly opaque world of exchange-traded funds.
The latest offer of this nature springs from ETF Securities, an exchange-traded fund issuer, which on Thursday launched the “world’s largest exchange traded currency platform” and Europe’s first. Here’s the release (our emphasis):
Europe’s first exchange traded currencies (Currency ETCs) have today commenced trading on the London Stock Exchange. ETF Securities has admitted 18 Currency ETCs to the Main Market, offering long and short passive exposure to G10 currencies versus the US Dollar.
Pietro Poletto, Head of ETFs and ETCs for London Stock Exchange Group said: “As the number one ETC exchange in Europe, and given London’s reputation as the global centre for foreign exchange trading, we are proud to be the venue of choice for issuers looking to bring this new type of product into Europe.
“We aim to offer investors access to a wide range of investment opportunities while retaining the benefits of simplicity, transparency and central counterparty security that are integral to trading on-exchange. As such we are delighted to continue leading the diversification of Europe’s exchange traded product offering by welcoming ETF Securities’ new products today.”
A good opportunity to play the carry-trade, right?
We’ve had a go at reading the 150-page prospectus to determine just what the products are about. In quick conclusion, the ETCs appear to be another fine example of how exchange-traded products are mutating from their transparent replication-based beginnings into ever more complex instruments.
First, it would be wrong to confuse these for exchange-traded funds anyway. They are investable units of exchange-traded ‘collateralised currency security’ notes — or in the words of fund issuers “complex, structured products” aimed at “sophisticated, professional and institutional investors” .
This means retail investors operating without the advice of independent financial advisors should really stay clear. UCITS-compliant funds can invest in them, but the ETCs themselves are not strictly UCITS products.
The type of financial whizz-kidery that brought us CDOs, meanwhile, appears to be thriving well in ETFs.
ETF Securities’ COO Nik Bienkowski confirms to us his ETCs are the first of their kind in terms of structure, anywhere in the world. As the prospectus notes:
Collateralised Currency Securities are being issued for the first time pursuant to this Prospectus and therefore have no trading record. There can be no assurance as to the depth of the secondary market (if any) in Collateralised Currency Securities, which will affect their liquidity and market price.
Which means, of course, there’s no precedent to look to.
So how do collateralised currency securities actually work? It’s complicated, so bear with us.
In the ETF Securities framework the whole thing depends — much like in the DB x -trackers model — on synthetic rather than physical replication of an index. This, the argument goes, achieves superior tracking for investors.
ETF Securities’ ETCs are based on Morgan Stanley’s MSFX Total-Return Currency Indices. The way they achieve that performance, however, is not by replicating the components of those indices, but by taking out a total return swap with a counterparty that assures the performance of that index.
In ETF Securities’ case that counterparty happens to be Morgan Stanley (and only Morgan Stanley for the time being).
The way the money flows is as follows:
Investors buy units of, for example, the long AUD Short USD ETC on the London Stock Exchange.
When enough units are purchased to raise the price of units relative to the NAV of the ETC — as implied on a constant basis by the relevant MSFX index (minus management, broker and transaction fees) — an authorised participant (AP) spots an arbitrage opportunity and offers to buy units at the NAV price direct from the issuer for cash, which he sells on for a risk-less profit to the market to ensure tracking.
Here though the AP does not deal with ETF Securities directly but via the ETCs’ chief counterparty, Morgan Stanley.
Morgan uses the proceeds it receives to hedge its total-return-swap exposure — but essentially can do whatever it pleases with the money.
To ensure that investors are protected in the event that Morgan Stanley fails to guarantee the performance of the index, Morgan Stanley pledges collateral to ETF Securities’ custodian — Bank of New York Mellon.
That collateral can be made up of any of the following: AA-rated G20 government bond, AAA-rated shares of government or treasury money market funds, AAA-rated supranational bonds, unsubordinated bonds issued by Ginnie Mae and any equity listed on “specified indices” anywhere in the world.
Bank of New York Mellon has the responsibility of monitoring the eligibility of the collateral, but to all extents and purposes, from what we can make out, Morgan Stanley determines the valuation on a daily mark-to-market basis.
Of course, if you were interested in what these actually consisted of, you’d be disappointed because there doesn’t appear to be any public record offered. All we know is that equities have to represent an over-collateralisation of between 105-110 per cent — i.e. be worth more than the underlying obligation by that percentage — and bonds between 100-102 per cent. If the collateral falls below those parameters Morgan Stanley is obliged to deliver the difference via a master repo agreement.
Meanwhile, we understand that Morgan Stanley’s position as chief counterparty does not make it ineligible for the role of authorised participant. In fact, from what Bienkowski tells us, the bank is currently listed among the ETCs’ APs.
What does all that mean?
A pretty cushy arrangement for Morgan Stanley, from what we can make out. Morgan can use the ETC to gain lucrative access to liquidity as and when it pleases, while sporting the ultimate money-making capability via its position as a Master authorised participant.
As for the investor — remembering the products were launched as a response to investor demand for “secure, transparent and liquid currency package”– it means a potential upside scenario of receiving all of the performance of a currency index, for relatively low management fees, but without any interest or dividend (no carry trade here then)…***see update below.
…and downside scenarios that include credit-exposure to Morgan Stanley, covered by a claim on potentially illiquid securities, as valued by Morgan Stanley. Compulsory redemptions at inopportune moments due to a myriad of different triggers. And in the event of counterparty default, a position third-in-line for repayment:
(a) FIRST in payment of all amounts then due to the Security Trustee and the Trustee and unpaid (including to any attorneys, managers, agents, delegates or other person appointed by either of them) in respect of each class to which such Counterparty Collateral Pool is 105 relevant under the terms of the relevant Security Deed and the Trust Instrument (as determined by the Security Trustee in its absolute discretion), and to payment of any remuneration and expenses of any receiver and the costs of realisation of the security constituted by the relevant Security Deed then unpaid, (for the avoidance of doubt, excluding any Redemption Amounts owed to the Trustee under the Trust Instrument);
(b) SECONDLY in or towards payment or discharge of all amounts then due and unpaid by the Issuer to the Currency Transaction Counterparty to which such Counterparty Collateral Pool relates under the Facility Agreement, ISDA Master Agreement or Global Master Repurchase Agreement with such Currency Transaction Counterparty;
(c) THIRDLY in or towards payment of all amounts then due and unpaid in respect of the Collateralised Currency Securities to which such Counterparty Collateral Pool is relevant on a pro rata basis as provided in Condition 13.5;
(d) FOURTHLY in or towards payment or performance of all amounts then due and unpaid by the Issuer under the Services Agreement to ETFSL (or any Affiliate with which the Issuer has entered into a Services Agreement);
(e) FIFTHLY in payment of the balance (if any) to the Issuer (without prejudice to or liability in respect to, any question as to how such payment to the Issuer shall be dealt with as between the Issuer and any other person).
Dare we say it makes more sense to go to a reputable counterparty in the FX market direct? Especially if it’s the longer term view you’re going for.
***UPDATE: November 17, 1630 GMT — Felix Salmon over at Reuters has been exploring these ETCs further, originally being stumped like us about how they can expose you to carry-trade interest returns (other than via US T-bill exposure).
Turns out it’s down to the way the index rebalances on a daily basis, which allows it to gain an overnight rate. As Salmon explains:
…the funds essentially buy currency forwards expiring tomorrow, sell them just before expiry, and roll over into a new short-dated forward. These forwards are extremely liquid, and since that constant rolling one-day exposure in the forwards market does an excellent job of reflecting the differences in local interest rates.