Counterparty Risk

To clarify the difference between the different types of tracker, let's review how they work.

Traditional ETFs

A traditional ETF holds the underlying securities that track the index, or at least a representative sample of them. The attraction of this arrangement, as with most mutual-fund-type structures, is that in the case of failure of the fund issuer, the investor has recourse directly to the pool of underlying shares or bonds. As the Borsa Italiana ETF site explains, for example, with regard to UCITS-compliant ETFs:

"It is a known fact that UCITS have segregated assets with respect to those of the companies, which take care of their creation, management, administration and marketing activities. Therefore, ETFs are not subject to the insolvency risk in the event of default of the above-mentioned companies."

If the issuer goes bust, the investor still has access to the basic securities.

Swaps-Based ETFs

There is, however, another kind of ETF that does not offer this same relationship—a swap-based ETF. A swap-based ETF depends on derivative contracts, often written by third parties, to provide exposure to the market. This creates the potential for a new kind of risk—that of the swap writer failing to fulfill its obligations.

In the case of a UCITS-compliant swap-based ETF, the counterparty exposure to the swap writer is capped at 10% of the fund's net asset value. This exposure can be reduced to a smaller amount, either by a policy of exchanging collateral between the fund and the counterparty to cover unrealised gains or losses, or by resetting the swap to zero (i.e., settling accounts, and starting again) on a regular basis. Here, one needs to check the relevant ETF prospectus to see what policy the manager follows. In a worst case scenario, an ETF owner could in theory be left 10% out of pocket if the swap counterparty failed to pay up.

It makes sense to understand whether your ETF is a traditional "in-specie"-based ETF that holds the underlying asset, or a swaps-based ETF that comes with counterparty risk.

Can we quantify the cost of the counterparty risk for a swaps-based ETF? In theory, yes, if we know who the swap counterparty is, and if we know whether there is any money due to the ETF from the swap counterparty that has not been covered by collateral. We could then work out how much it would cost to remove the counterparty risk by buying a credit default swap ("CDS")—an insurance policy to hedge against the risk of the counterparty failing to perform.

In practice, however, it would be very difficult to obtain the necessary information to do this. Most ETF managers only offer an annual snapshot of fund collateral, for example, and may not reveal the names of swap counterparties at all. The risk is indeterminate, if real.

ETNs And ETCs

With ETNs and ETCs, things are different. Here, the investor has direct counterparty exposure to the issuer (in the case of ETNs) or to third parties guaranteeing the securities' performance (Shell Treasury for ETF Securities' energy ETCs, and AIG for most other ETCs—with the exception of some precious metal ETCs which are backed by physical holdings).

The potential exposure is also larger, as the whole value of the ETN or ETC is tied to the financial security of the swap provider.

Fortunately, we can more easily quantify the "cost" to an investor of owning the underlying investment via an ETN/ETC by checking how much one would have to pay to remove the issuer's or third party guarantor's credit risk from the equation, using credit derivatives.

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