ETFs: Collateral damage

The type of securities held as collateral in ETFs is under greater scrutiny, prompting issuers to become more transparent. Helen Fowler reports

If you buy an ETF you might reasonably assume the product holds investments in the index it is supposed to track. However, that is not necessarily the case and many funds do not hold anything as obvious as the constituents comprising the index. Instead they own something known as collateral.

Collateral is a form of guarantee. Although it might sound like a complex, technical issue, collateral underpins the $131bn of assets in swap-based products in the European ETF universe, which represents 45% of the total industry according to BlackRock data. It also features in physically replicated funds that engage in securities lending.

Collateral is an essential part of synthetic or swap-based ETFs, although it is often overlooked as an integral component of the fund.

Swaps are a type of derivative, a financial contract that synthetic ETF providers enter into, in order to gain the return of the fund’s underlying index. While the swap counterparty agrees to deliver the performance of the index, the ETF itself holds a basket of securities – the collateral – as an insurance policy in case the swap counterparty goes bust.

Yet, collateral can constitute anything within a range of securities stipulated by the issuer and does not necessarily reflect the stocks comprising an ETF’s underlying index. In the event of another Lehman-style disaster, if a bank or counterparty failed, collateral could be all that ETF investors have left. In such a scenario, there is also the risk the value of the collateral could fail to match the value of the index, falling short.

Collateral awareness
Collateral has been placed under the microscope in recent months. ETF investors are trying to find out more about what they are buying, and as they burrow into the fine print, many have been surprised to discover that the collateral backing their FTSE 100 fund is, for example, actually made up of Japanese equities.

However, there is no requirement for a fund’s collateral to match the assets of the index it tracks. As a result, there may well be a mismatch between an investor’s desired position and their actual exposure. Concerns have also surfaced that investment banks – the main providers of synthetic ETFs – might use lower quality assets for ETF collateral.

It comes as little surprise that in July last year the Committee of European Securities Regulators (Cesr), now known as the European Securities and Markets Authority (Esma), said ETF providers should improve the quality of information about collateral on their websites.

Providers have responded to the regulator’s demand. Credit Suisse, Europe’s fourth largest ETF provider with assets of more than $15bn, launched a range of swap-based ETFs in September providing full daily disclosure on all collateral holdings. The firm also committed to making sure the collateral value matches that of the indices the funds track. As a result, counterparty risk only arises from intraday differences between changes in the index and the fund’s holdings.

 “We are going to move in the direction of more transparency,” said Dan Draper, global head of Credit Suisse ETFs. “We want the same quality, transparency and level of trust that you get from physically replicated funds.” Draper said it was essential for investors to ask questions of swap-based providers to find out their counterparty exposure, and how often it was marked to market.

The firm’s website is open to any investor seeking to find out the type of collateral posted against an ETF. Credit Suisse holds blue-chip European equities as collateral, drawing from the Eurostoxx 600. In practice, around 94% of the collateral is in the top 200 companies in the index. The firm resets the swap daily, at the end of each trading day, meaning it is marked to market and any increase in value since the last reset is paid to the fund.

Deutsche Bank followed Credit Suisse’s example in December with a similar undertaking to provide daily updates of collateral and swap exposures for its ETFs. Investors in db x-trackers can go online to access the most up-to-date details on the size of their net swap exposure as a percentage of net asset value on a specific ETF. They can also find out the make-up of the collateral used to minimise net counterparty risk exposure.

“Although we have long provided collateral and ‘substitute basket’ information upon request from our clients, we are now publishing this information online on a daily basis,” said Thorsten Michalik, global head of db x-trackers.