Disclosure in ETF collateral holdings: the battle heats up

A well written article in IndexUniverse highlights the arguments of physical and derivative-backed ETF providers that their models are superior.

Collateral Battles
Paul Amery – October 28, 2011

According to Edouard Vieillefond, deputy secretary general of France’s securities regulator, the AMF, the public battles between providers of physical and synthetic exchange-traded funds come down to a single main issue: how both types of issuer provide backing for their funds’ holdings.

“The risks involved in those physical ETFs that lend stocks and in synthetic ETFs are similar,” said Vieillefond in a telephone interview with IndexUniverse.eu. “In both cases the collateral is ultimately what guarantees that the investor gets repaid in the case of a counterparty failure. So everything boils down to collateral and collateral policy.”

“Understandably, there’s a dispute between providers of different types of ETFs over business models,” added Vieillefond. “We’re keen that the technical debate on regulatory standards shouldn’t become polluted by this tough exchange of views between different ETF companies, or influenced in any way by their private interests.”

Vieillefond expressed satisfaction that regulators’ interventions have prompted greater disclosures about fund structure amongst ETF issuers.

“We’re happy that ETF providers are now offering greater levels of transparency over their collateral policies. One of the objectives of the G20 Financial Stability Board report on ETFs that came out earlier this year was to trigger such a reaction.”

Since 2010, most European issuers of synthetic ETFs have started to publish details of their funds’ “substitute baskets” or collateral holdings, including the extent to which derivatives-related fund exposures are backed and the individual securities used for the backing (although terminology in Europe’s ETF market is not standardised, issuers of synthetic funds using unfunded swaps tend to refer to their funds’ substitute “assets” or “basket”, while those using funded swaps use the term “collateral”, with such collateral being pledged or transferred to the fund by the derivatives counterparty).

iShares, Europe’s largest issuer of physically backed ETFs, is now also publishing details of the collateral held on behalf of those of its funds that lend securities, although the firm doesn’t disclose what proportion of each fund is are being lent out, nor the names of individual counterparties.

But in addition to ensuring investor protection, collateral policies have a direct impact on financial institutions’ profitability. The economic incentives underlying derivatives transactions and securities lending policies were highlighted in the response by ETF issuer Lyxor to the recent discussion paper from the European Securities and Markets Authority (ESMA) on UCITS ETFs and structured UCITS.

“All [UCITS] structures, whether ‘physical’ or ‘synthetic’, wish to benefit from the difference in repo rates between the asset they own, directly or as collateral, and the assets [to] which they are exposed,” argued Lyxor in its submission, explaining its view that there is little underlying difference between the two types of ETF.

The repo rates Lyxor refers to are the cost (expressed as an interest rate) of raising secured finance against a basket of securities. In a synthetic ETF any difference between the repo rate on the substitute or collateral basket held by the fund and the repo rate on the index securities represents an additional source of income for the issuer. In a physical ETF a similar interest margin is earned, but in a transaction that is effectively a mirror image of that undertaken by a synthetic ETF: index securities are lent out by the physical ETF, generating interest income, being replaced temporarily by other securities that have a lower lending value. In both structures, fund managers typically retain a proportion of the additional earnings generated.

iShares has taken a diametrically opposing view to Lyxor (and to other synthetic ETF providers who have expressed similar views), arguing in a recent document “ETP Due Diligence” that the two ETF categories—physical and synthetic—are fundamentally different. While it said that physically replicating ETFs are “simple and easy to understand”, “transparent regarding costs and underlying fund holdings” and have “no or limited counterparty risk in the case of securities lending”, what iShares called “derivatives replicating ETFs” (i.e., synthetic funds) “differ significantly from physically replicating ETFs in terms of risk and complexity”.

It’s unclear which way the wind will blow in the regulatory debate. According to some observers, the proposed split (contained in last week’s MifID II proposals) of UCITS funds into “complex” and “non-complex” categories could land synthetic (derivatives-based) ETFs on one side of the fence and physically replicated funds on the other. This would suggest agreement with the iShares view of the world.

But not all regulators agree.

“It’s too simplistic to suggest that physically replicated ETFs are good and synthetic ETFs are bad. Both types of fund need new rules,” said Vieillefond of France’s AMF. “And there’s a broader issue that needs to be addressed by regulators, which is how non-fund structures, for example structured products, notes and bank certificates, are treated. Any categorisation of investment products into complex and non-complex categories—which we support—should cover not just UCITS funds, but all these other structures as well.”

Meanwhile, mooted revisions to regulators’ technical standards may end up narrowing the gap between different types of ETFs.

In its discussion paper, ESMA suggested two policy changes that could impact issuers’ profitability and how their ETFs are managed and structured. First, ESMA proposed harmonising collateral rules between synthetic and physical ETFs (collateral policies for derivatives transactions in synthetic ETFs and for stock lending in physical ETFs are currently not identical, while there have also been some differences in implementation at the national regulator level across Europe). Second, ESMA raised the prospect of tightening up collateral policies so that “the quality and type of assets constituting the collateral matches more closely the relevant index”.

Unsurprisingly, given that differences in quality between the index stocks and those substituted for them (whether as collateral backing for a derivatives contract or for stock lending transactions) can generate significant extra revenues for issuers, there’s little appetite for the latter proposal in fund managers’ published responses.

In its reply, for example, EFAMA, the Europe-wide industry body for fund managers, stated that “a large majority of [our] members does not consider that provisions on the quality and the type of assets constituting the collateral should be further developed as proposed by ESMA. CESR’s Guidelines on Risk Measurement already provide for quite stringent collateral requirements for UCITS, and our members consider that they are sufficient”.

Lyxor, in its reply, went further, and suggested that if the economic incentive to swap index securities for collateral (or to lend fund assets) were removed, such activities probably wouldn’t exist in the first place.

“Requiring collateral that is similar to the index would be like asking fund managers, when they lend securities, to receive collateral that is similar to the securities they lend. But then there would be no economic advantage (…) and the securities would simply not be lent,” said the issuer.

Indeed, some of those replying to ESMA’s paper have suggested moving to a narrow definition of UCITS, where such collateral swaps would be prohibited. Francis Candylaftis, former head of Italian fund manager Eurizon, argued in his response that funds sold to retail investors should be barred both from using derivatives and from lending their securities.

But if differences over collateral policy have been highlighted by ETFs, the significance of the collateral debate extends far beyond this fund management sector. And, judging by regulators’ growing interest in the subject, collateral battles may even intensify.

“Collateral rules are important for the whole of the financial market, not just for ETFs,” said the AMF’s Vieillefond. “Collateral is a huge issue for the European Market Infrastructure Regulation (EMIR), since it is critical for how clearing houses will operate. It may be a utopian view, but I’d like to see a broad-based approach to policy—rather like the work being done on Packaged Retail Investment Products (PRIPS) at the European Commission—to achieve a coherent set of rules for collateral at banks and other financial institutions, encompassing all types of transactions.”

The original post is here.

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