Here’s our favourite part from the FSB report.
It refers to the practice of collateral sweating — loading your ETFs with the cheapest collateral out there and swapping it to guarantee the performance of a specific index (our emphasis):
In addition, the incentives behind the creation of synthetic ETFs may not be aligned along the ETF chain, especially as conflicts of interest can arise from the dual role of some banks as ETF provider and derivative counterparty.
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.
For instance, in diagram 1, the collateral basket for a S&P 500 synthetic ETF could be less liquid equities or low or unrated corporate bonds in an unrelated market. 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.
l
In short, risks increase if the bank considers the synthetic ETF structure as a stable and inexpensive source of funding for illiquid securities. ETF investors may not always have sufficient control over collateral arrangements to enable them to prevent such a situation.
One case in particular comes to mind – that of DB X-trackers, which famously stuffed most of its European synthetic ETFs with Japanese equities over and above any other stock.
Back in the day when we first covered this story we were told by the bank it was a perfectly reasonable and justifiable structure, the banks’ clients had no complaints about it and it was all the more safe because all DB X-trackers’ products were over-collateralised.
Since then, DB X-trackers has made significant strides to become more transparent about the collateral it holds with much more regular disclosure (in contrast to the half-yearly updates the bank used to give out) . Whether this was a response to other products coming to market, which made a point of differentiating themselves in this respect, is hard to answer. But it doesn’t seem like coincidence.
And the fact the market has evolved to offer increasingly more multi-swap provider structures also shows that providers themselves see the vertically-integrated model as vulnerable — both to regulation and client interest.
A hint of what the regulators feel on this front in any case is further highlighted in the FSB note:
Important considerations relate to the rules for selecting the collateral, the screening of its credit quality and its liquidity, valuation practices and haircut determination, and segregation of assets. The existence of regulatory or other limits regarding the derivative exposure would also help contain the risks mentioned above.
As for the risks associated with products that generally promise on-tap liquidity and rehypothecation (as well as Bogan’s can an ETF collapse point), the FSB is pretty clear:
While benefiting formally from market making arrangements, ETFs may nevertheless experience liquidity disruptions. In principle, ETFs offer on-demand liquidity to investors while they are in some cases based on much less liquid underlying assets. Therefore, in the event of a market sell-off or an unwind in any particular ETF, there is a risk that investors massively demand redemption. Depending on the specific ETF arrangements, redemptions could be made “in-kind” which would alleviate liquidity pressures.
However, were redemptions to be made in cash, this could raise issues as to the exit strategies and liquidity risk of ETF providers and swap counterparties. Further study would also be useful for assessing the potential impact of heavy ETF trading on the liquidity and the price dynamics of the referenced securities, particularly if they do not have an active secondary market (e.g. emerging market ETFs). In the same vein, thin margins on plain-vanilla physical ETFs create incentives for providers to engage in extensive securities lending in order to boost returns.
Some ETF providers are said to generate more fee income from securities lending than from their traditional management fees. Since securities lending is a bilateral collateralised operation, it may create similar counterparty and collateral risks to synthetic ETFs. In addition, it could make the liquidity position of the ETF fragile, by challenging the ability of ETF providers to meet unexpected liquidity demands from investors, particularly if outflows from ETFs become significant under severe stress.
A prevalence of securities lending could create a risk of a market squeeze in the underlying securities if ETF providers recalled on-loan securities on a large scale in order to meet redemptions. In addition, the use of ETFs as collateral in a long chain of secured lending and rehypothecation may create operational risks and contribute to the build up of leverage. In this regard, it is worth noting that some jurisdictions impose reporting and disclosure requirements (e.g. on-exchange registration) on securities lending that would contribute to lower risks.
Well said the FSB. We couldn’t agree more.
Now for the ETF industry’s “the regulators just don’t understand how our products function, we pose no risk” backlash.
Note from FT Alphaville to PRs: Offers to re-educate should be emailed directly to the author as per the usual process.
No cold calls please.
Related links:
Beware your Japan ETF exposure - FT Alphaville
Kauffman: ETFs are the problem, not HFT – FT Alphaville
Are some traders gaming the system via settlement failures? - FT Alphaville
SEC probes ‘ETF-stripping’ by insider traders — FT Alphaville