Lyxor has launched London's first exchange-traded note, which unlike its US counterparts is fully collateralised to minimise counterparty risk. But is there a downside to collateralisation? And just how transparent are exchange-traded products when it comes to counterparty risk? John Ferry reports When Lyxor, the fund management subsidiary of French bank Société Générale and a leading provider of exchange-traded funds (ETFs), decided it wanted to list a product that would give European investors exposure to the price of gold, it faced two problems. First, the Ucits III regulations that govern the European fund market prohibit linkage to a single commodity. The answer? Wrap the product as an exchange-traded note (ETN) rather than an ETF. Deciding to debut an ETN was the simple part. The second problem was more subtle. Unlike traditional ETFs, a listed structured note is not backed by a specific pool of assets, but rather, just as with an over-the-counter note, the product simply amounts to an agreement by the issuer to give the buyer the returns of an index or a benchmark. That means the buyer of the note has to take on counterparty risk to the structured note provider, and this type of risk has become a major concern to investors since the demise of Lehman Brothers. To assuage those fears and to ensure its new ETN would be as competitive as an ETF, Lyxor took the innovative step of fully collateralising its note by backing it up with a pool of AAA rated funds and government bonds from the Eurozone. "To be Ucits III eligible, a product has to comprise at least five underlying securities, so we couldn't do this as an ETF," says Daniel Draper, London-based global head of Lyxor's ETF and ETN businesses. "We wanted our new gold product to feel just like a fund, to have the same on-exchange trading and liquidity benefits and to minimise or eliminate counterparty risk." Draper says he wanted to improve upon the ETN model that has sprung up in the US, where a number of ETNs are listed without additional collateralisation. Similarly, he says he is not aware of any European certificates that have been collateralised. In the case of Lyxor's gold ETN, a special-purpose vehicle (SPV) holds the collateral, and in the event of Société Générale going bankrupt the ETN holders have recourse to those assets. The provision of the additional collateral pool presents investors with some clear benefits in terms of risk reduction, but it also comes at a cost. Because OTC structured notes are generally issued as unsecured senior debt via a bank's regular medium-term note programme, in pricing those notes dealers have to price in a funding spread. The funding spread is formulated by the bank's treasury department and varies depending on how cash-hungry the bank is and the risk the market places on it as a creditor. With banks eager to boost their capital bases at the same time as the banking sector remains subject to previously unheard-of volatility, funding spreads have widened dramatically. To put this in perspective, before the banking crisis kicked in, a highly rated large international bank might typically have been able to apply a funding level of perhaps 40 or 50 basis points (bp). This year, an equivalent funding level could easily be 100-200bp or more. Because the funding spread is often priced directly into an OTC note, a wide funding spread gives more value to the investor. But a fully collateralised note does not have this advantage. Because it is fully collateralised, that funding spread is not priced in. Not being able to benefit from wide funding spreads is a disadvantage at the moment, says Draper, but he believes in the longer term his fully collateralised product offers better value. "We feel that for our clients the advantage of the collateral outweighs the disadvantage on the funding level. When the credit markets do settle back down then we'll be on a comparable footing with uncollateralised note providers," he says. Draper says the gold ETN will be just the first of a series of new collateralised listed notes products. "At the moment we're going to concentrate on rolling out more in commodities, but this gives us the flexibility to do any asset class," he says. Another asset class that it would be difficult to give exposure to under the Ucits III framework is foreign exchange, for example. The first issuer of ETNs was Barclays Capital, which debuted the products in New York in 2006. The bank lists a number of commodity ETNs in the US as well as currency-based ETNs and other alternatives. It has not, however, opted to collateralise those products. Uwe Becker, Barclays Capital's Frankfurt-based head of retail investor solutions for Europe, says there are disadvantages to the structure. "We decided to establish a non-collateralised range of products. With a collateralised product it becomes extremely difficult for the investor to assess the counterparty risk, because to do that effectively would involve looking into the pool of assets. It's much easier to establish a fair value for your product when you know exactly what your credit risk is," he says. One of the key benefits of ETNs is the transparency and clarity they bring to the structured notes market, but setting up an SPV with a pool of collateral in it that the ETN buyer can call on in the event of issuer bankruptcy takes away some of that transparency, and it makes doing proper due diligence on the product much more difficult, says Becker. "The primary reason for the success of our ETNs is the simplicity of the products," he adds. Becker says the success of ETNs in the US - NYSE Arca currently lists 85 ETNs - shows that investor appetite for the products is not dependent on collateralisation. However, he does not rule out using the collateralisation method in future, but adds that it would only be for certain products - such as exposure to a precious metal, for example, where an ETF format would not be possible in Europe - and where the collateral pool is very transparent and it is easy for the investor to assess the risks held in it. The possibility of seeing a proliferation of collateralised ETNs emerge in Europe as an alternative to new ETFs is therefore unlikely. They are likely to be used only when Ucits III rules prohibit the setting-up of a fund. And there are no signs that collateralised ETNs will emerge in the US either. When assessing the risks associated with an ETF investment, many investors are inclined to take it as a given that counterparty risk is not an issue. Who cares if the ETF provider goes bust when the ETF itself holds physical assets that are bankruptcy remote from the provider? What a lot of investors may not realise is that when looked at closely, there are in fact counterparty risks inherent in ETFs that should be taken into account. "All ETFs that are listed in Europe have quite a robust infrastructure behind them because they are regulated under Ucits III, but regardless of whether the ETF uses swaps or traditional replication, there could be elements of counterparty risk involved there as well," says Manooj Mistry, London-based UK head of db x-trackers, Deutsche Bank's ETF business. Counterparty exposure There are two main ways in which ETF providers take market exposure. What Mistry refers to as traditional replication involves the ETF directly buying and selling underlying assets in order to track an index. The other method is to use swaps to take exposure synthetically. Both methods have elements of counterparty risk. Typically, the underlying stock held by a traditional replication ETF is lent on to other counterparties - perhaps other banks or hedge funds that want to short the stock. The counterparties post collateral in return for the stock but clearly there is some counterparty risk there. The ETF provider earns a premium for lending out its underlying assets, and there are no rules that stipulate where that premium should go - be it to boost the fund's returns or as profit to the fund provider. However, the market norm is for the premium to be split equally each way. Although it does lead to hidden counterparty risks, lending out underlying assets is not an idiosyncrasy of the ETF market. "Stock lending is a very common activity," says Mistry. "Index funds and ETFs are low-margin businesses, and this lets those businesses generate extra revenues while also helping the performance of the underlying funds." Synthetic ETFs use index swaps to replicate the performance of an index. Here the ETF does hold a basket of assets but it enters a swap agreement to get the actual return on the index over time. All of Deutsche Bank's ETFs use swaps to take their exposure. "The purpose of the swap is to provide a more efficient way to track the index, which is especially useful when you have a broad benchmark. You're essentially transferring the tracking risk away from the fund and on to the swap counterparty. In our case that's Deustche Bank, which has the systems and capability to do the tracking much more efficiently," says Mistry. Ucits III allows for synthetic index replication and stipulates that the exposure to the swap counterparty as measured has to be based on the mark-to-market of the swap. Take the example of an equity ETF valued at 100 at inception. On that first day, 100% of the ETF's value will be invested in equities, while the value of the swap will be zero. If the index then rises 5%, it is the swap component that gives the additional 'five' of value, while the equity basket remains flat at 100. Under Ucits III, the maximum the mark-to-market on the swap can be is 10% of the fund's net asset value (NAV). Providers therefore typically set a buffer lower than this level, and if the swap reaches the barrier then the swap resets, which means the bank counterparty pays the value of the swap to the fund and that money gets invested in more assets. db-x trackers, for example, sets its buffer at 5%. European synthetic ETFs therefore bear counterparty risk to their swap provider, but this is effectively capped at a maximum of 10% of NAV. Ucits III, through its liberal precedents on funds using derivatives, effectively encourages the use of synthetic replication by ETF providers - which is why most ETF providers in the US tend to be traditional fund managers, such as Vanguard and State Street, whereas the leading providers in Europe are bank offshoots that use synthetic swaps. So what does all this tell us about counterparty risk on exchange-traded products? First, that collateralised ETNs are emerging to be roughly on a par with ETFs in terms of counterparty risk. Counterparty risk itself however is never clear-cut. Collateralised ETNs, and traditional and synthetic ETFs may all minimise counterparty risk to the listed product provider, but there is still counterparty risk there, and any such risk at the moment could be of concern to investors....
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