Understanding exposure to counterparty risk is crucial
RISK is an acceptable, even a welcomed part of trading. Every trade comes with some risk attached; it’s just a case of knowing what the potential problems are and being comfortable with them.
But as the financial crisis showed, pinpointing where the risk lies is not always so straightforward – even big institutions didn’t always understand the full extent of their exposures. Consequently, it is worth investors taking some time to understand how products work and find out their exposure. Exchange-traded products (ETPs) are no exception given that they are often backed by large investment banks and that the providers engage in securities lending to provide added returns and minimise the impact of fees on performance.
And with the spectre of a banking crisis in Europe looming, counterparty worries are back in investors’ and regulators’ minds. The Bank of England turned the spotlight on these products in its latest Financial Stability Report (FSR) published last month. In the FSR, the Bank noted that some of its contacts in the financial markets have questioned the transparency over the securities lending part of some ETFs,
“One risk is that in the event of failure of the firm providing the ETF, the ETF investor could end up holding something other than the intended index exposure and possibly face liquidity constraints on exiting their investment. Given the unfortunate developments in the securities lending markets in the run up to the current crisis, this should not be under emphasised,” the FSR said.
Swap-based funds, which use total return swaps to gain exposure to an index, have counterparty credit exposure embedded in the funds through the various derivative transactions, the report added.
So how do ETF providers try to mitigate the risk of counterparty exposure? With physically-backed exchange-traded funds, such as the range offered by BlackRock’s iShares, you only have counterparty risk with BlackRock and any institutions that are involved in securities lending.
Nizam Hamid, head of sales strategy at iShares, says: “In the case of an ETF provider going bankrupt the investor would have direct access to those underlying assets, which are all segregated in a completely different account. You would have a choice of either gaining access to the underlying securities via an in specie redemption or you could appoint another manager.” An in specie redemption is where you get access to the underlying assets.
In terms of its lending, Hamid says that iShares overcollateralises and only accepts G10 government bonds and liquid equities. “We test for the liquidity of the equities that we take on board and if they are not liquid then we won’t accept them. We review the value of collateral on a daily basis to make sure that we are always fully covered.” For bonds, iShares requires 103 per cent collateral and for equities it is 112 per cent. It also monitors the credit risk of its counterparties 24 hours a day.
With a swap-based ETF, the worst-case scenario would be a maximum loss of 10 per cent of the ETF’s net asset value (NAV), which is the regulatory limit to the swap’s exposure. However, db x-trackers’ Manooj Mistry says that in practice, there is a buffer that has increased from 2-3 per cent a few years ago to 5 per cent today. With its fixed income ETFs, db x-trackers resets the swap exposure every time it reaches 5 per cent. With its equity ETFs and alternative ETFs it follows the over-collateralised approach and demands 105 per cent of the fund’s NAV. This was introduced in February 2009 as a result of people’s concerns about potential counterparty exposure, explains Mistry.
More recently, some ETF providers such as ETF Securities (on its equity and commodity platform ETFX) and Source have started to offer multi-counterparty exposure whereby the swaps are backed by a number of banks. This disperses exposure further and while providers are not obliged to spread exposure evenly across the counterparties, Source does provide investors with a weekly sheet detailing its exposure to each counterparty. The idea is that, should one counterparty default, the swap can be transferred to another backer.
It might seem time-consuming but understanding where your risk lies is, and what would happen in a worst case scenario is important. If you have learnt nothing else over the past few years, it is to assume that nothing is impossible.