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Remembering Collateral Costs
By Paul Amery | 20 November, 2009   

(You can read the relevant blogs here, here and here.)

ETF Securities’ currency ETC investors earn their returns from three sources. The first is the spot price movement in the currency concerned over the holding period; the second is the compounded overnight interest rate differential between the currency they are long of and the currency they are short of (this part comes from rolling the currency position forward daily via a “spot-next” transaction, which has an implied interest rate component); and the third is a component to reflect a strategy of investing in the relevant Morgan Stanley currency index on a collateralised basis - either the one month US T-Bill rate or the European overnight interest rate (EONIA), depending on which base currency the ETC uses.

For more details on the index methodology, go here.

My initial thought when looking at this new tracker product was that a policy of rolling a currency position forward daily would incur significant trading costs. However, I’ve been assured by a currency market expert that the annualised cost of the daily roll for the currencies in the initial stable of ETCs comes to only around 8 basis points on average – and less in the case of the most liquid currency pairs (1.2 basis points per annum for EUR/USD, for example). That’s almost insignificant.

I think the currency ETCs will be a success. As ETF Securities’ Nik Bienkowski says, “they’re basically bringing institutional money market interest rates and spreads to the average investor.”

However, there’s one component of the return that doesn’t favour investors so much, and that relates to the ETCs’ collateral. Generally speaking, the fact that they are collateralised makes currency ETCs attractive when compared to other investment products offering similar market exposures – CFDs, for example. If your CFD provider goes bust, your money will almost certainly disappear. In the case of the currency ETCs, collateral is available to back up the issuer’s return promise.

Full details of the ETCs’ collateral policy are given on pages 56-57 of the prospectus. In summary, the currency counterparty (Morgan Stanley International plc) can place into the ETCs’ collateral account with a third party custodian (BONY) a range of assets, including government bonds, AAA-rated government money market funds, supranational and agency bonds, and equities (subject to certain “haircuts” for equities and longer-dated bonds to reflect their higher risk).

But it turns out that collateral has a cost. Other things being equal, it’s the cost for a bank of obtaining funding using the given basket of assets as security, and it’s usually expressed as a margin over LIBOR.

Turning this the other way round, if you as a counterparty (let’s say an ETF or an ETC) lend money to a bank and the bank gives you a portfolio of bonds or equities as security, you’d expect to earn a LIBOR-plus return.

But in the case of the currency ETCs you don’t – you earn only the T-Bill rate or EONIA. In fact, this morning the FT reported that US T-bill rates have turned negative, so investors now have to pay to own them rather than being compensated for doing so. Perhaps they haven’t been paying attention to the recent rise in the US government’s CDS spread – but that’s another matter.

The question of collateral cost doesn’t apply only to ETCs. In essence, exactly the same situation arises with ETFs. With a swap-based ETF, the bank that guarantees the index return (the swap provider) places a basket of collateral with the fund. If it were to obtain funding elsewhere using the same collateral the bank would usually have to pay a spread over LIBOR, but with an ETF the provider typically guarantees only to pay LIBOR. The ETF is a cheap source of financing for the bank, in other words.

Andrew Clavell, author of the Financial Crookery blog, recently wrote about just this subject. Clavell looked at a db x-trackers MSCI Taiwan ETF, and pointed out that Deutsche Bank might have had to pay LIBOR plus 50 basis points to obtain funding using the basket of equities that the ETF owned as collateral on 31 December. It’s not clear what return the ETF was earning on its leg of the swap, Clavell says, but he doubts that it’s LIBOR plus 50.

A securities finance expert I spoke to this morning explained that, given that Deutsche Bank is the swap counterparty in this example, the financing cost might be nearer to 25 basis points over LIBOR than 50. The credit quality of the borrower institution is important, in other words, and your collateral “cost” as an investor is higher, the lower the quality of the bank concerned.

This partly explains how Deutsche Bank is able to charge a zero fee on its DJ Euro Stoxx 50 ETF, and also why the bank can offer return “enhancements” to the fund – it’s sharing some of the swap earnings it’s making. (There are some other ways in which ETF providers can earn extra revenues outside the funds, notably from tax arbitrage on dividend payments, and these can also contribute to the enhancements.)

Incidentally, I don’t agree with Clavell’s blog title (“How Synthetic ETFs Rob Investors Blind”), nor with his suggestion that ETFs should hold only AAA-rated bonds as collateral. For a start, physically backed ETFs’ practice of lending out index securities in exchange for extra returns, using collateral as backing for the transactions, is from an economic point of view exactly the same as what swap-based ETFs are doing. And imposing a requirement that ETFs should hold only top-rated bonds as collateral presents a major correlation risk (if you’re an equity fund investor you don’t want all your collateral held in the form of bonds, as their performance is typically uncorrelated to that of equities and would generate frequent margin movements - Clavell in fact makes this point in a later addition to his original blog entry).

But can investors assess collateral costs? With difficulty, if at all, it turns out. Swap-based ETF providers only show their funds’ collateral make-up to investors twice a year (although some issuers apparently do provide it on request). If you invest in a physically backed ETF you typically have no idea to whom securities have been lent and on what specific terms. And in the case of ETF Securities’ ETCs, there’s no disclosure of the composition of the collateral basket at all.

Complicating things further is the fact that Europe’s regulators do not have a single set of collateral rules for ETFs under the UCITS regime, so the Dublin regulator’s view of what is acceptable collateral for a swap-based ETF may be different from that of the CSSF in Luxembourg or the AMF in Paris.

Should investors be concerned by all this? It depends from which perspective you approach the question. If you compare ETFs or collateralised ETCs with many other tracker instruments that land you with full counterparty exposure to the issuer then ETF/ETC risks are marginal by comparison. On the other hand, with many ETF issuers now appearing to claim that “my version of the DJ Euro Stoxx 50 is better than theirs” or even that “my regulator’s collateral rules are stricter than theirs”, more transparency on the precise holdings of ETFs and ETCs, looking through to all collateral exposures, is surely overdue.

Only the daily publication of the collateral basket make-up and any securities lending exposures in ETFs and ETCs will enable investors to assess what risks they are incurring and whether they are being adequately compensated for them.

 

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