[This article was first published on the Learn section of our website, which is a comprehensive database of educational articles]
If there's anything we've learned from recent financial crises it's that counterparties matter.
There are two different kinds of synthetic ETFs on the market today: unfunded and funded models. The type of counterparty risk each model offers is different, so it pays to understand how they work.
Unfunded vs. Funded
The unfunded structure was the original model used for synthetic ETFs.
Let’s say that a fund wants to gain exposure to the Indian stock market. A physically replicated fund would take in money and go out and acquire individual stocks trading in India.
With an unfunded swap, something different takes place.
First, the fund will enter into a swap agreement with a counterparty bank. In exchange for a fee, the bank promises to provide the fund with the return of the Indian market.
The bank then tells the fund to acquire a “substitute basket” of highly liquid stocks or bonds. These securities are often sourced from the bank’s own balance sheet, and don’t necessarily have anything to do with Indian stocks.
The fund takes the substitute basket and posts it as collateral in a custody account. In addition to the fee, the bank receives the pattern of return from this collateral balance.
Is It Safe?
For UCITS funds, the value of the collateral, which is marked-to-market daily, must always equate to at least 90% of the net asset value (NAV) of the fund. This means you shouldn’t lose much more than 10% of the fund’s NAV, even in the event your counterparty goes bankrupt.
Until recently, unfunded models were considered riskier than funded models because they were less transparent and often had only one counterparty—usually the issuer’s parent company. However, many issuers have recently raised their minimum swap requirements, posting collateral in excess of 90% of the fund’s NAV. Some issuers even maintain full collateralization.
Even with higher collateralization rates, investors should be wary of the collateral, which may be more or less volatile, and more or less liquid than the securities in the fund’s underlying basket.
In an attempt to further reduce risk, an increasing number of issuers are using multiple counterparties to distribute credit risk more widely. Many have also started to increase transparency regarding the contents and characteristics of the substitute basket.
Funded structures can be thought of as the second generation of synthetically replicated funds. They came into existence in the aftermath of the 2008 financial crisis. In a funded structure, the issuer basically directly gives the counterparty the cash from its investors in exchange for the returns of the underlying index.
The counterparty (the swap underwriter) uses the cash to purchase a basket of securities, and posts this substitute basket as collateral in a separate account that is pledged to the fund. In this way, the collateral is technically the property of the fund and, as such, provides investors with recourse should the counterparty fail.
While UCITS rules state that the counterparty risk cannot exceed 10% of the fund’s NAV on any given day, fully funded ETFs are often 100% collateralized or sometimes even over-collateralized.
Unfunded Or Funded?
The difference between the two structures really comes down to swap risk and access to collateral in the event of counterparty default. Traditionally, funded swaps have been considered to have lower swap risk, as they are fully collateralized, if not over-collateralized.
However, many issuers using unfunded models have caught up and gone beyond the 90% collateral threshold mandated by UCITS. Unfunded funds also have direct access to the substitute basket, which can expedite any liquidation that might arise from default.
Interestingly, some issuers have even begun to mix an unfunded and funded structure within an ETP to offset various risks, while maintaining full collateralization of the swap. Regardless of the model, issuers are increasingly attempting to lessen, minimize or even spread out the credit and swap risks associated with synthetically replicating ETPs.
With either structure, the risks are relatively small, but certainly not negligible.