Physically-backed ETFs: a matter of risk

If buying a physically-backed ETF sounds like a safer alternative to synthetic products, it might be time to reconsider that belief as Helen Fowler discovers in the first of a series looking at some of the issues raised by regulators’ comments on ETFs

Physically-backed ETFs may initially seem more robust than their synthetic (or swap-backed) rivals. But they pose the same dangers as their derivatives-backed competitors, according to no less an authority than the UK’s Financial Stability Board (FSB).

The similarities occur because almost all physically-backed products resort to a process known as securities lending, which involves lending out the stocks in an ETF portfolio in return for a small fee. “Since securities lending is a bilateral collateralised operation, it may create similar counterparty and collateral risks to synthetic ETFs,” concluded the FSB.

The FSB is not alone in its concerns over physically-backed (also known as in specie) ETFs. Judging by the babble of concerns raised by regulators around the world, physically-backed products may not necessarily be as sturdy as their name suggests.

Institutions as august as the International Monetary Fund (IMF), the Bank of International Settlements (BIS) and the European Securities and Markets Authority (Esma) are all alarmed by the potential dangers posed by securities lending, an activity that occurs in almost all of the world’s $1.2trn physically-backed ETFs.

Providers of physically-backed funds – meaning products that favour direct replication of an index and buy up its components – routinely lend out the securities in them to hedge funds and other institutions for short-selling. In return they receive a small fee, often as little as just a few basis points, from the borrower.

Regulators are unhappy. They want to beef up the rules around securities lending in ETFs. A swarm of acronyms has descended on the industry, determined to bring greater transparency to the process.

Default risk
The regulators’ concern centres on what might happen if a borrower were to default. “Securities lending introduces risks arising from borrower default notwithstanding the provision of collateral,” said Esma, in a recent policy document.

Securities lending could also make the liquidity position of the ETF ‘fragile’, warned the FSB in an April report. In a crisis, providers might not be able to meet all the demands for redemption from investors.