14/08/2011: A warning on synthetic ETFs class

An interesting, much overlooked working paper from the Bank for International Settlements, shines some light on recent innovations in financial engineering. It also contains a warning of the rising probability of the next asset class meltdown.

BIS Working Paper Number 343 (available here) “Market structures and systemic risks of exchange-traded funds” by Srichander Ramaswarmy starts from some historical stylized fact from finance.

“Crisis experience has shown that as the financial intermediation chain lengthens, it becomes complicated to assess the risks of financial products due to a lack of transparency …at different levels of the intermediation chain.”

Despite the crisis, however, the appetite for structured credit products is now growing, especially amongst the institutional investors with access to low cost funding (courtesy of the lax monetary policies). The problem, according to Ramaswarmy, is finding higher risk and higher returns products to beef up institutional portfolia returns – the very same problem identified back in 2002-2003 when, following the collapse of ICT bubble, tech stocks (high risk, high return products of the late 1990s) were wiped out.

“This time, financial intermediaries have responded by adding some innovative features to existing plain vanilla …exchange-traded funds (ETFs)... The structuring of these funds initially shared common characteristics with that of mutual funds. In particular, the underlying index exposure that the ETF replicated was gained by buying the physical stocks or securities in the index.”

As a result, of investors appetite for higher returns while simultaneously desiring high liquidity, “ETFs have moved away from being a plain vanilla cost- and tax-efficient alternative to mutual funds to being a much more complex and diverse array of products and replication schemes…” using derivative products. “As the volume of such products grows, such replication strategies can lead to a build-up of systemic risks in the financial system.”

Here are some interesting facts – all from Ramaswarmy:

• As of end-2010, there were close to 2,500 ETFs offered by around 130 sponsors and traded on more than 40 exchanges around the world.
• Global ETF assets under management rose from $410 billion in 2005 to $1,310 billion in 2010 (Chart left hand side panel) roughly 5.7% of the global mutual fund industry.
• “Almost all of the ETFs that are benchmarked against fixed income or equity indices in the United States are plain vanilla structures that involve” physical holding of securities that comprise the underlying index. “In Europe, roughly 50% of the ETFs are plain vanilla types, and the rest are replicated using synthetic structures (Chart, centre panel).”
• “Regulatory rules …encourage the adoption of plain vanilla structures in the United States [including notification, stress-testing and control over derivatives held, especially over-the counter derivatives]… The UCITS regulations that apply in Europe, on the other hand, permit exchange-traded as well as over-the-counter derivatives to be held in the fund…”
• As the result of more lax regulation in Europe, a significant share of more risky ETFs benchmarked to emerging market assets is “domiciled in Luxembourg or Dublin… ETFs benchmarked to emerging market assets now total $230 billion (Chart, right-hand panel).”
  

Synthetic ETFs replicate the index using derivatives such as unfunded total return swaps or the funded swaps as opposed to owning the physical assets.

The former type of a swap is a transaction between two counterparties to exchange the return arising from an asset for periodic cash flows. Under this swap system:

• ETF can end up holding physical securities / assets that are completely different from the benchmark index that the ETF is supposedly replicating.
• Underlying securities can incorporate potential conflicts of interest between the funding counterparty and the securities it pledges.
• “The composition of the assets in the collateral basket can change daily... Under UCITS regulations, the daily NAV of the collateral basket, …should cover at least 90% of the ETF’s NAV...”
  

An alternative is the funded swap under which, “the ETF sponsor transfers cash to the swap counterparty, who then provides the total return of the ETF index replicated. This transaction is collateralized… [usually to 110-120% of the NAV, using a system that] can potentially lead to delays in realising the value of collateral assets if the swap counterparty fails…”

These synthetic ETFs, per Ramaswarmy “transfer the risk of any deviation in the ETF’s return from its benchmark [the tracking error risk] to the swap provider... However, there is a trade-off: the lower tracking error risk comes at the cost of increased counterparty risk to the swap provider.”

In addition, many synthetic ETFs are at a risk of non-transparent “possible synergies that might exist between the investment banking activities of the parent bank and its asset management subsidiary or the unit within the parent bank that acts as the ETF sponsor. These synergies arise from the market-making activities of investment banking, which usually require maintaining a large inventory of stocks and bonds that has to be funded. When these stocks and bonds are less liquid, they will have to be funded either in the unsecured markets or in repo markets with deep haircuts. By transferring these stocks and bonds as collateral assets to the ETF provider sponsored by the parent bank, the investment banking activities may benefit from reduced warehousing costs for these assets…”

In other words, if ETF sponsor is cross-linked to the funding bank, the cost savings to the investment bank from synthetic ETF collateral are directly and inversely linked to the quality of the collateral held by the ETF – the lower the quality, the higher the savings. As Ramaswarmy puts it, “for example, there could be incentives to post illiquid securities as collateral assets.”

Furthermore, liquidity regulation, “such as the standards now proposed under Basel III, may also create incentives to use synthetic replication schemes” to artificially reduce the run-off rate on short maturity assets. This can be used to allow banks “to effectively keep the maturity of the funding short” and inflate bank’s liquidity positions.

All of the above benefits can yield short-term gains to ETF investors, but they come at a cost of:

1. increased risk to financial markets stability
2. lack of transparency in the quality of collateral held and liquidity positions
3. decreased transparency on ETF leverage and composition,
4. decreased liquidity of the ETF collateral can be further compounded by securities lending, and etc
   

Ramaswarmy summarizes these as follows: “Drawing on [the 2000-2008] experience, there are a number of channels through which risks to financial stability could materialise from ETFs, especially when product complexity and synthetic replication schemes grow in usage. They include:

1. co-mingling tracking error risk with the trading book risk by the swap counterparty could compromise risk management;
2. collateral risk triggering a run on ETFs in periods of heightened counterparty risk;
   
3. materialisation of funding liquidity risk when there are sudden and large investor withdrawals; and
4. increased product complexity and options on ETFs undermining risk monitoring capacity.”

Core ETFs’ risk minimisation mechanism – 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.”

And there is a warning note to the investors: “by employing a variety of markets and players to replicate their benchmark indices, ETFs complicate risk assessment of the end product sold to investors. There is little transparency and no investor monitoring of the index replication process when this function is taken over by the swap counterparty. Financial innovation has added further layers of complexity through leveraged products and options on ETFs.”