Collateral And Exchange-Traded Products

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%.

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.

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.

And while UCITS rules impose quite strict diversification requirements on a fund's assets, or on an approved index for a UCITS-compliant tracker product, these diversification rules (often referred to as the "5/10/40" rules) do not extend to the collateral itself held by a swap-based ETF. However, some issuers do choose to back their swap-based ETFs with collateral consistent with the rules.

Critics of swap-based ETFs have pointed out that the composition of the collateral basket may bear little or no resemblance to the index being tracked, being in unrelated securities or even in an entirely unrelated asset class, and that the basket's composition is typically only revealed in the ETFs' annual and semi-annual report and accounts, leaving investors in the dark about what is in there the rest of the time. One leading swap-based ETF provider countered that there may be no disclosure at all about the collateral held and counterparty exposures incurred when ETFs' securities are lent out, as typically happens for funds that use an in specie replication methodology.

While some swap-based ETF providers have stated their willingness to reveal the collateral basket composition more frequently, on request, one pointed out to me the operational complexities that this would present, which might necessitate an increase in costs. This issuer also pointed out the ample scope for confusion between the "perfect basket" or "implied fund constituents" for a swap-based ETF—the securities constituting the index being tracked, whose composition is typically updated daily on ETF issuers' websites—and the securities held in the collateral basket.

Exchange-traded notes (ETNs) and other exchange-traded products, such as exchange-traded commodities (ETCs), operate outside the UCITS framework, since they typically offer exposure either to single assets (for example, a particular commodity) or to indices that do not meet UCITS diversification requirements. A year ago no ETNs, and only a few ETCs (those tracking physical metals), had any effective collateral backing, so an investor typically carried full counterparty exposure either to the issuer, or to an intermediary company guaranteeing the return. However, following the September failure of Lehman Brothers and the subsequent near-collapse of AIG, some issuers started to collateralise their trackers.

ETF Securities' Commodity Securities range was relaunched on 20 October last year, with the creation of a Securities Intermediary (Bank of New York Mellon), which holds collateral pledged to the issuer by AIG Financial Products. The Commodity Securities ETCs represent more than half the firm's exchange-traded commodities ("ETCs") by number, though about one fifth by value (most assets invested in ETCs are in those backed by physical metal, under the ETFS Metal Securities and Gold Bullion Securities ranges, while around 6% of ETCs are uncollateralised, with performance guaranteed by Shell Trading Switzerland). More recently Lyxor has launched a collateralised ETN tracking gold, and plans to issue further notes under the same programme.

For ETF Securities, the collateralisation of the majority of its ETCs appears to have met with investor approval. Assets under management in the AIG-backed Commodity Securities (excluding forward, short and leveraged versions) fell from $3.3 billion in July 2008 to around $1 billion in October, partly reflecting the fall in commodity prices, but also withdrawals due to counterparty concerns. Assets have since rebounded to $2.1 billion, and have doubled since December.

Lyxor's Dan Draper said that his firm is seeking to throw light on the true cost of providing collateral by including a variable collateral charge in the Lyxor gold ETN's total expense ratio. This charge currently runs at an annual 74 basis points on top of the flat annual 0.30% fee, although Draper said that he expects the variable component to drop if and when credit markets stabilise. The charge relates specifically to the cost of funding the collateral held in the issuer's asset compartment backing the ETN: an S&P AAAf-rated eurozone government bond fund or government bonds.

The Lyxor gold ETN's structure is not directly comparable to ETF Securities' physical gold trackers—ETFS Physical Gold and Gold Bullion Securities—since the two ETCs are backed by allocated gold bars, held with a custodian, whereas Lyxor's ETN is collateralised by government bonds, with a parent bank guarantee on top.

The gold-backed ETCs are cheaper than Lyxor's ETN on an all-in basis (carrying annual total expense ratios of around 40 basis points) and are backed by bullion itself, rather than by bonds or funds. Lyxor is less expensive when only comparing only the fixed fees (30 basis points for the Lyxor ETN versus 39 and 40 basis points, respectively, for the ETCs).

Lyxor has admitted that it is targeting those categories of investor that may prefer the ETN for regulatory or tax reasons, or to diversify issuer exposure.

When Lyxor adds other commodity trackers to its range, competing more directly with the AIG-backed Commodity Securities range of ETCs, investors will need to assess Lyxor's use of full collateralisation, using a Luxembourg-based issuer and a parent bank (Société Générale) guarantee on the exposure, and compare it to ETF Securities' structure, which involves the pledge of securities by AIG Financial Products to the account of the intermediary bank, BoNY Mellon in New York, to back the performance of the ETCs. The collateral provided by AIG is subject to certain "haircuts", and ETFS points out that it has the right to issue a "Notice of Exclusive Control" to BoNY Mellon in the case of an AIG default, effectively freezing the collateral account and allowing it to liquidate the assets.

For a non-institutional investor, or for those without access to specialist legal advice in securities and bankruptcy law, the comparison between these two firms' products, and those of other, similar trackers seems a complex task. On Lyxor's ETN website, for example, in the "product comparison" section, the firm suggests that, when comparing the ETNs to other exchange-traded products, "counterparty risk must be assessed and depends on the signature quality of the issuer or of the guarantor, if any. If collateral is in place, the quality of such collateral must be analysed, along with the related covenants." ETFS argues that it is independent from any guarantor and is in a position to ensure security holders' best interests, and an orderly wind-down of its products in the case of a default.

IndexUniverse.eu approached lawyers specialising in European regulatory and securities finance at London-based firms Clifford Chance and Freshfields to seek their views on the relative merits of the two types of structure, but neither firm was prepared to comment.

As far as collateral disclosure goes, the Lyxor ETN Long Gold prospectus reveals that Lyxor is currently using the Lyxor ETF EuroMTS 15+Y fund, which carries an AAA "fund" rating from S&P. ETF Securities' physical metal ETCs are backed by allocated bullion, as was described earlier. For the ETCs in its Commodity Securities range, ETF Securities currently does not reveal the actual securities being pledged by AIG.

Collateralisation is an ongoing trend in the financial markets, and it remains a key factor underlying the attractiveness of exchange-traded funds. Nevertheless, both inside and outside the UCITS rules there is a great diversity of practices used in providing the collateral to back tracker funds and notes. There is also limited disclosure of actual collateral held, in contrast to the profuse information available on the index or asset being tracked. Since the exchange-traded products market is very far from a unified model in collateral policies, it pays investors to be aware of how the backing to their investments is provided.