If you invest in a swap-based ETF, an ETF that lends out its underlying shares, or in any other tracker product that backs its return with a basket of assets, collateral questions arise. What is the collateral? How liquid is it? How visible is it? And is there an associated cost? There are some subtle differences in the way collateral backing is provided to ETFs, ETNs and ETCs, which are worth being aware of.

Although the credit crunch has made counterparty risk a hot topic, and has increased investor demands for collateral to back investment products, a trend towards the collateralisation of financial market exposures has been ongoing for years. State Street estimates that, since 2000, the total value of assets held as collateral has increased at the startling annual growth rate of 35%.

Collateral For ETFs

For almost all European ETFs, counterparty exposures must be managed within the UCITS rules. The rules act as a broad legal framework and have gained general acceptance as a stamp of quality. The UCITS stamp has proved popular beyond the region, helping to promote ETFs in Asia and Latin America too.

These counterparty exposures were covered in detail in two features published on www.indexuniverse.eu last autumn, available here and here. But, in summary, for an ETF that uses a physical (or "in specie") replication methodology (i.e., owning all, or most of the securities in the index tracked), counterparty exposures would arise when securities are lent out. For an ETF that uses swap-based replication, there will be risk exposure to the swap counterparty, which is often the parent bank of the ETF issuer.

In both cases, counterparty risks are offset by the use of collateral. 

For ETFs that are involved in securities lending, which are typically those using physical index replication, our survey revealed that issuers typically overcollateralise the fund's counterparty exposure to between 102-110% of the value of the securities lent. In addition to the absolute level of overcollateralisation, attention needs to be paid to the type of assets held. In many collateral agreements lower-quality or less liquid collateral may be subject to a "haircut"—a discount applied to the market value. Thus a greater absolute level of collateralisation with lower-quality collateral might be seen as equivalent, in risk terms, to a lower percentage with higher-quality collateral. If cash received as collateral is reinvested then there may be additional risks incurred as a result of the investment policy.

For swap-based ETFs, UCITS rules specify that collateral has to be provided to a value of at least 95% of the fund's net asset value (when the swap provider is a non-European bank), 90% otherwise. In practice, our survey revealed that issuers typically reduce this percentage further; db x-trackers, in a continuation of this trend, revealed last week that it plans to pledge additional collateral to an account with its ETF custodian in order to remove any remaining exposure.

While the UCITS rules specify the overall level of collateral backing that must be provided for swap-based ETFs, the way in which these rules are implemented and, specifically, what represents acceptable collateral, is down to individual European regulators. In any case, collateral is accepted at its market value (i.e., no haircuts are applied).

If equity collateral is accepted, it might seem riskier at first glance than collateral consisting of fixed income securities. However, the credit crunch fallout may have inverted this traditional relationship, since it has been certain areas of the credit markets that have become illiquid, while equities in general remain relatively easy to trade.

For fixed income-based collateral, there is also the need to review the specific types of bonds permitted under the rules. While a collateral policy based on a minimum credit rating may in the past have offered a great deal of security, the ratings agencies' stamp of approval has proved unreliable during the credit crunch.

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