Synthetic ETFs: true villains or just misunderstood?

Emma Cusworth looks at what affect the eurozone crisis has had on synthetic ETFs

As the eurozone crisis came to a crunch over the summer, some of Europe’s biggest banks saw a dramatic widening of their credit default swaps (CDS) as well as credit downgrades. Given the role of some of the worst-affected banks as swap-counterparties in synthetic ETFs, investors have been asking what impact these developments have on counterparty risk.

The protections offered by Ucits and providers own collateralisation and resetting policies have come into sharp focus. Questions also remain about whether providers using a single swap counterparty, particularly where both exist within the same banking group, should move to a multi-counterparty structure.

Although markets appear to be punishing some synthetic providers, for those in-the-know, these products still represent a highly regulated and very transparent investment vehicle. Furthermore, questions are increasingly being asked about the risk involved in physical ETFs that use securities lending. While the focus has been on synthetic products, experts argue there is little difference in risk terms between the two.

Since early August, CDS on many European banks have widened dramatically: by 4 October 2011 spreads on five-year CDS for Société Générale (SocGen) doubled to 352bps, peaking at 435bps mid-September; Credit Suisse widened 85% to 185bps (peak 211bps); Deutsche Bank widened 66% to 191bps (peak 225bps); BNP Paribas widened 75% to 263bps (peak 309bps) and Credit Agricole widened 70% to 263bps (peak 322bps). SocGen and Credit Agricole were downgraded by Moody’s in mid-September and share prices slumped across the board.

Investors and regulators have questioned the impact of an increasingly stressed banking sector on the counterparty risk in synthetic ETFs, particularly where the provider and counterparty belong to the same banking group and where only one counterparty is used. The question of what happens should a swap counterparty default, has come sharply into focus.

Synthetic ETF providers say they have seen little impact resulting from spread widening and downgrades. Simon Klein, Lyxor’s head of ETFs Europe says: “There is no link between the CDS evolution of banks and ETF assets. AUM has fallen because investors have been selling the most liquid products in their flight to safe havens and away from equities, particularly in Europe.

“In the case of Lyxor, SocGen’s CDS or ratings are not at stake, because the counterparty exposure is reset to zero on a daily basis,” Klein continues. “Furthermore, we are moving to a position of over-collateralising swap exposure, which also means there is no counterparty risk intra-day.”