In its working paper on ETFs, the BIS goes into considerably more detail than the IMF. The BIS paper’s author, Srichander Ramaswamy, examines the nuances of synthetic ETF structures and their associated risks, the economic incentives that are driving the growth in synthetic tracker funds and the possible opportunities for regulatory arbitrage that ETFs present. Ramaswamy also notes wider systemic risks to the financial sector that may result from the widespread adoption of such ETFs.
The BIS notes that synthetic (swap-based) ETF structures have become popular as a way of reducing the potential tracking error problems that occur when ETFs’ traditional technique of physical replication (buying the underlying index securities) is used in less liquid markets.
But, says the BIS, there are two distinct types of synthetic ETF—using funded and unfunded swaps—with resulting differences in the counterparty risks assumed by the end investor, and also with differing balance sheet implications for the bank providing the swap to the fund.
In an ETF following the unfunded swap structure, the ETF sponsor exchanges cash with the swap counterparty for ownership of a basket of collateral. The ETF sponsor also contracts with the counterparty to pay it the return on the collateral basket, while the counterparty pays the index return to the ETF sponsor (and thereby to the fund’s investors).
Since it becomes the beneficial owner of the collateral basket, the ETF sponsor can sell the basket’s securities in the case of a counterparty default and then repay the fund investors, says the BIS.
By contrast, the second type of synthetic ETF, using funded swaps, sees the payment of cash by the fund sponsor to the swap counterparty, who simultaneously contracts to pay the index return to the sponsor. This contractual obligation is secured by a pledge of collateral “into a ring-fenced custodian account to which the ETF sponsor has legal claims,” says the BIS. “But unlike in the unfunded swap structure”, the BIS continues, “the sponsor is not the beneficial owner of the collateral assets. This can potentially lead to delays in realising the value of collateral assets if the swap counterparty fails.
Offering a synthetic ETF range gives a cheap source of financing to a bank, the BIS says, noting that firms involved in market-making activities need to finance their inventories of stocks and bonds. If these inventories are illiquid, they will have to be funded either in the unsecured markets—expensively—or in repo markets, using deep haircuts (discounts to face value).
However, continues the BIS, “by transferring these stocks and bonds as collateral assets to the ETF provider sponsored by the parent bank, the investment banking activities may benefit from reduced warehousing costs. Part of these cost savings may then be passed on to the ETF investors through a lower total expense ratio for the fund holdings”.
But, says the BIS, echoing the IMF’s argument, the poorer the quality of the assets posted to the ETF as collateral, the greater the cost savings accruing to the investment bank. In other words, there’s an economic incentive to post illiquid securities to the ETF, reducing investors’ security.