Source ETF—the new collaborative exchange-traded products venture that launched its first set of funds today—promises to shake up the European ETF industry. With the backing of Bank of America Merrill Lynch, Goldman Sachs and Morgan Stanley, it is throwing serious institutional weight behind an ETF push.

IndexUniverse.eu spoke today with three directors of the new outfit—Ted Hood, CEO; Peter Thompson, director of strategy; and MJ Lytle, director of marketing—to ask them about their firm's structure, their first product launch and future development plans.

IU.eu: You've launched your ETFs and T-ETC commodity trackers under what you call an open architecture platform, with three founding members. How do you see this developing, and what would be the ideal number of participants in the Source platform?

Source ETF (Hood): From the current three, we'd see the ideal number of participants as somewhere between five and 10, and we're in active discussions with a number of potential partners. At some point, you'd want to stop adding partners, as the complexity of the arrangements would diminish the value investors would get from the diversification.

IU.eu: How does your platform compare with the ETF Exchange that ETF Securities is planning?

Source ETF (Hood): So far we've only seen a press release about the ETF Securities platform, which doesn't contain a great deal of detail, so we don't really have a basis yet on which to compare. I'd like to add, though, that we're not just a platform, but a stand-alone company, a specialist provider of exchange-traded products.

IU.eu: How is Source capitalised?

Source ETF (Hood): We're an independent, separately-capitalised company, currently wholly-owned by the three companies mentioned in the press release [Bank of America Merrill Lynch, Goldman Sachs, Morgan Stanley]. We don't disclose precise details of the shareholdings—that's for the shareholders.

IU.eu: You mention on your Web site that overall counterparty risk in the ETFs will be capped at 4.5% of NAV, and that the swap to which counterparty risk relates will be written by one of the three shareholding banks. How do you decide which bank gets to write the swap for an ETF creation, and how does an investor know whose counterparty risk he incurs?

Source ETF (Hood): First of all, I want to mention that, for the ETFs which we offer, there is a third-party investment manager, Assenagon Asset Management, and they are responsible for the day-to-day management of the funds. By and large, we expect that swaps will be allocated more or less in accordance with where the assets are raised. Since these are funds, everyone shares equally in the counterparty risk, irrespective of when a particular investment was made. We have procedures in place to ensure that we have diversification on an ongoing basis, and it's the responsibility of Assenagon to ensure that these are followed.

IU.eu: If I'm investing in a particular fund, can I see what the counterparty exposures are?

Source ETF (Hood, Thompson): We're not planning on publishing that on an ongoing basis, but we have procedures in place to ensure that there is diversification within every fund. We will also have no more than 4.5% exposure to counterparties in aggregate. So, compared to a typical UCITS fund where you can have up to 10% exposure to a single counterparty, we have a lower limit, and we diversify that exposure as well. Currently the exposure is split between three counterparties, but in time, we expect this number to increase. As creations and redemptions will take place on a daily basis, counterparty exposure will be changing dynamically.

IU.eu: What will the collateral held in the swap-based ETFs consist of? Will there be periodic disclosure of the collateral held?

Source ETF (Hood): The funds invest in liquid, listed equity securities, and then use a performance swap to exchange the return on the collateral for the index return. The securities in the collateral basket may be similar to the index constituents, or quite different, but we do expect a fair amount of overlap. It depends on what the product is, and we monitor the correlation, liquidity and diversification of the collateral held. There are of course regulatory requirements for the disclosure of collateral held, and we've had some discussions about the frequency of disclosure, but haven't decided yet.

IU.eu: How does the collateral mechanism work for the T-ETCs?

Source ETF (Hood): The principal is completely invested in Treasury bills. The issuer of the securities then enters into a total return swap to obtain the commodity performance. Those total return swaps represent a possible counterparty exposure to the banks writing the swaps, and these are collateralised on a daily basis by G7 government bonds, which of course include Treasury bills, and cash.

IU.eu: What motivated your decision to list your ETFs and T-ETCs only in Germany? Doesn't this reduce their attractiveness to retail investors in other European markets?

Source ETF (Hood): We took a hard look at this, and one of the things we're keenly focused on is the trading component of exchange-traded funds. We see two gaps between the European ETF market and that in the US. One is the penetration gap, in terms of the percentage of managed assets represented by ETFs, and the other is a liquidity gap, which represents the turnover of ETFs. We think that each gap partially explains the other. We fully recognise that, in Europe, there is something of a trade-off between the number of listings and the assets that you raise, but we are committed to reducing the liquidity gap, and we think that the trade-off that we make in order to reach that goal is to trade in a single place. So we have no immediate plans to cross-list our ETFs and T-ETCs in other markets.

IU.eu: What are the future launch plans? We reported last month that you have 50 ETFs authorised for launch by the Irish regulator.

Source ETF (Thompson): We'll be launching additional funds this spring, and as you've said we have a number of ETFs authorised for launch. It's our intention to add funds in all relevant asset classes, and we're going to do this in a comprehensive and thoughtful way. We structured the company so Source could act as a clearing house or centre for innovation, so that its partners—whether banks, broker-dealers, market-makers or potentially asset managers—can bring ideas to the platform. There's already a great deal of expertise among the existing partners in fixed income, equities and commodities, so we see Source as a centre for the development of innovative new products. We'll be launching a number of these later this year and in coming years.