How Do They Work?

How do the Eonia and other money market ETFs achieve their objective? Through swaps.

Rather than investing directly in the overnight interbank deposit markets, an investor's money is used to buy a portfolio of assets. (In Lyxor's case, this portfolio is specified in the prospectus as equities; in db x-trackers' case, it is simply defined as "transferable securities.") Using these securities as collateral, the fund enters into a total return swap with a market counterparty (presumably the parent bank in each case), delivering to the bank the return on the underlying securities in exchange for an interest cash payment tied to overnight cash rates.

The collateral held must be diversified according to UCITS rules, which specify that no single issuer's securities may exceed 10% of the fund's value, and that the value of securities in issuers which individually constitute more than 5% of the fund may not exceed 40% in total (the "5/10/40 rule"). There are some additional higher limits for EU government-backed securities and covered bonds, but we won't go into those here.

If this seems a bit technical, it is one of the core elements of the UCITS regime, and it gives a clue as to why these money market ETFs have grown so much over the last year. With the intensification of the credit crunch and the rapid loss of faith in the safety of some financial institutions, counterparty risk is at the forefront of investors' concerns. Add to that the discrediting of the agency ratings system over the past few years-which failed to warn investors of the risks in many structured finance securities-and you have a strong market for a search for even safer places to park your cash. The cash ETFs offer inherent diversification and so are seen as a safer bet than direct, unsecured loans to banks in the money markets, let alone structured finance instruments that may have been given an AAA rating a year ago but are now worth far less than face value, and may well be unsellable in any case. While credit market problems continue, demand for these ETFs is likely to increase.

Decreased Risk 

It is worth pointing out that, while counterparty risk is reduced by investing via an ETF, it is not eliminated. The db x-trackers structure takes, in my view, the preferable approach, seeking to minimise the OTC counterparty risk by collateralising the swap daily and/or by resetting the swap if the mark-to-market value becomes too high. The Lyxor ETF has a looser limit-merely capping the swap counterparty exposure at 10%, which in any case would be the limit under UCITS. I haven't been able to confirm how the recently launched EasyETF funds operate in this regard.

Will money market ETFs continue to grow? Clearly their further success will depend on the level of interest rates in each currency zone, both relative to inflation and relative to longer-term bond yields. If the European Central bank were to reverse its current relatively tough stance and cut rates to below the inflation rate-as the Fed has done-many investors would no doubt cash in and leave. Also, there is increasing competition from deposit rates, with some banks paying interest at well above the market rate to attract funds. Here, investors will have to weigh the potential of earning some extra return against the increased counterparty and liquidity risk of deposits, when compared to the ETFs' inbuilt diversification and ease of trading. With bank failures on the increase, money market ETFs look well-positioned.

Paul Amery is the European correspondent for IndexUniverse.com. He can be reached at This e-mail address is being protected from spambots. You need JavaScript enabled to view it .

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