More On Counterparty Risk (Swap-based ETFs)

October 14, 2008

With the rise in popularity of swap-based ETFs, should investors be concerned about counterparty exposures? surveys industry practices.

The turmoil of the last few months in the financial sector has made every investor concerned about potential exposure to failing banks. Counterparty risk is no longer an esoteric subject, but has jumped to the very top of the list of questions to be asked when making an investment in exchange-traded products.

While ETFs benefit from being backed by collateral (when compared to ETNs and other, similar debt obligations), there are still some potential counterparty exposures involved. First, there is a difference between European swap-based ETFs (where there is potential counterparty exposure to the swap provider, albeit capped at 10% of the ETF's net asset value, under UCITS rules) and in specie ETFs (which hold the securities in the underlying index, or at least a sample of them). Second, there can be potential counterparty exposures resulting from the lending of an ETF's securities by the manager.

In this week's feature we will focus on how swap exposures are managed for swap-based ETFs. surveyed a number of leading European ETF providers and posed them a number of questions in relation to both swap-based ETFs and securities lending. The managers that have participated in the survey are iShares, Lyxor, db x-trackers, EasyETF, XACT, ETFLab and ETF Securities. BBVA, the Spanish ETF provider, explained that it had only in specie ETFs, and did not lend its ETFs' securities.

All answers refer to European-domiciled ETFs only.

1) What is the current total number of your ETFs and how many of these are swap-based?

  • iShares - 143 ETFs, of which 19 are swap-based (these are primarily managed from BGI's German office in Munich)
  • Lyxor - 143 ETFs, of which all 143 are swap-based
  • db x-trackers - 86 ETFs, of which all 86 are swap-based
  • EasyETF - 58 ETFs, of which 37 are swap-based
  • XACT - 11 ETFs, none swap-based
  • ETFLab - 10 ETFs, none swap-based
  • ETF Securities - 13, all swap-based 

IU comment - an interesting variety of structures, with Lyxor and db x-trackers offering only swap-based ETFs, iShares, XACT and ETFLab offering only or primarily in specie products, and easyETF offering both.

2) Who is the swap counterparty (in the case of multiple swap counterparties, please list all)? Please give the full legal name(s) of the counterpart(y/ies).

  • iShares - Bayerische Hypo- und Vereinsbank AG (Member of the UniCredit Group - UniCredit is A+/Aa3 rated on its long-term debt from S&P and Moody's, respectively)
  • Lyxor - Société Générale, (currently AA-/Aa2 rated on its long-term debt from S&P and Moody's, respectively)
  • db x-trackers - Deutsche Bank AG (currently rated AA-/Aa1 on its long-term debt from S&P and Moody's, respectively)
  • easyETF - no details given - comment that "swap counterparties are selected by our risk department in a very conservative fashion"
  • XACT - not applicable
  • ETFLab - not applicable
  • ETF Securities - Citigroup Global Markets Limited and Merrill Lynch International Bank Ltd  

IU comment - db x-trackers and Lyxor use their parent banks, unsurprisingly, as the swap counterparty. iShares's choice of counterparty reflects the Munich location of its swap-based ETFs. Of the three given names Deutsche Bank has - by one notch - the highest credit rating, though pay attention to the CDS market for a market-based view of credit risks, as the established credit rating agencies have done a poor job at spotting potential problems.

3) How do you assess and monitor counterparty risk?

  • iShares - BGI's Credit Risk Group conducts regular due diligence, focussing on indicators such as capital ratios, profitability, liquidity, trading activities, and risk management systems.
  • Lyxor - Counterparty risk is directly with Société Générale and the Lyxor risk department monitors the exposure on a daily basis.
  • db x-trackers - The investment management function for the db x-trackers ETFs is outsourced to a third party, State Street Global Advisers (SSgA). SSgA is responsible for monitoring the counterparty exposure of each db x-trackers ETF. The monitoring and assessment of the counterparty exposure is an integral part of the daily valuation and operational process for each ETF.
  • easyETF - Counterparty risk is very closely monitored by our risk department. A strict and very conservative counterparty list is regularly updated according to analysts' research. We tend to combine best pricing with best name and favour our internal desks, should they be competitive on the quote.
  • XACT - not applicable
  • ETFLab - not applicable
  • ETF Securities - Swaps are marked to market each day (this valuation is independently verified) and the exposure measured against the funds' NAV. ETFSL have set maximum exposures for each counterpart (currently 5% for Citi and 10% for ML. We expect to add more swap parties in the future.


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