Understanding the counterparty risks
We have seen over the past two years a significant increase in regulatory concerns due to the rapid growth in exchange traded funds (ETFs) and other types of exchange traded products (ETPs).
Broadly, those concerns may be categorised under four headings. First, ETFs that use derivatives to replicate their index and especially so where the product provider and the derivative counterpart are part of the same corporate group. Second, the risks associated with securities lending, which is more typically confined to physically replicating funds, and third, the increased complexity of products and exposures, especially leveraged and inverse offerings.
Fourth, and to a significantly lesser emphasis, the risks associated with unregulated exchange traded products.
Widening the debate
The focus of this debate has largely narrowed to a battle between physical and synthetic providers centring around the relative risks of counterparty exposures in physical funds with lending programmes versus synthetic replication techniques.
However, it is surprising that the risks posed globally by unregulated ETPs – which make up12% of the $1.7 trillion invested in combined ETF/ETP universe and 30% of the 4,497 products at the end of February 2012 according to the ETF Global Insight monthly report – are not afforded a higher priority.
It is important to remember that when we look at counterparty exposure across ETFs and ETPs the associated risks from an investor perspective are significantly different depending on the type of investment vehicle and the level of regulation associated with it.
For the investor purchasing through his brokerage account, however, these products all trade and settle in an identical fashion and the varying degree of risk and counterparty exposure will not be immediately apparent.
In this context, it is worth reminding ourselves that for all the vigorous debate within the ETF community, we are talking about exposures within a highly regulated investment funds framework.
While there may be concerns around the quality and liquidity of swap collateral and liquidity, or the robustness of a securities lending programme, it is important not to lose sight of the fact that from an investor’s perspective, their investment is through a highly regulated entity and any and all exposures have strict parameters.
The important and ongoing debate around systemic as opposed to investor concerns in fund products should not detract from the fact that the investment itself is well protected in its fund wrapper.
Once we look to investment in non-fund ETPs we see that there is effectively no regulation either of the investment exposure itself or the delivery mechanism of that exposure.
The most common non-fund ETP exposure is through a debt security. This structure may vary from a simple note programme issued by a bank where an investor has, in addition to his investment risk, 100% exposure to the issuing bank, to more complex structures utilising special purpose vehicles and collateralisation programmes. These ensure effective segregation of assets between different types of exposure – an automatic feature of fund structures – and the elimination of counterparty risks.
Mitigate the risks
As unregulated structures however, it is incumbent on the investor to ensure he or she understands those risks and the mitigating factors the promoter introduces (or, more pertinently, does not introduce).
This leads us back therefore to the position of our retail investor investing through his brokerage account who might not even see the prospectus before trading.
The fragmented, absent or lack of equivalence across the regulation of ETFs and ETPs was expressly recognised in the European Sales and Marketing Association’s (ESMA) recent consultation paper on ETFs and other Ucits issues. ESMA was of the view that investment products with broadly similar characteristics should be subject to the same regulatory requirements – addressing the disparity in investment risk across ETPs – and that investors should have an equivalent level of regulatory protection, addressing the disparity between counterparty and structural risks in fund and non-fund ETPs.
The challenge now for regulators in Europe is to ensure that across all the various regulatory initiatives currently in flight – Prips, MiFID, MiFIR, Ucits V, AIFMD – that this view articulated by ESMA is realised without allowing inconsistency and regulatory arbitrage across a range of competing product offerings.
The subset of this challenge is that within the focus on reform of ETFs it is important that increased prescription around ETFs does not benefit the non-fund ETPs and push investors into effectively unregulated platforms or allow them to invest in structures unsuitable to their objectives or comprehension of the risks involved.