Credit Suisse’s head of ETFs, Dan Draper, closed a press event held by the bank earlier this week by pointing to the value of an ETF range to any bank concerned by regulatory developments. Credit Suisse is preparing an expansion of its own European ETF platform, which is likely to include a number of synthetic (swap-based) funds in addition to the existing ones using direct (in specie) replication. While the costs of maintaining an ETF range – listing, legal and index licensing fees – run into a few million dollars – peanuts for most firms – there are clear benefits for a bank in having ETFs, Draper argued.
First, there are the natural synergies with a bank’s trading and prime brokerage operations. If you run synthetic ETFs, you can make use of the portion of your market makers’ trading inventory that is hard to lend out by putting it into your ETF range as collateral. There are also opportunities for dividend-related tax arbitrage.
But having an ETF range may have a less visible “option value” to banks as well, Credit Suisse argues.
One of the unwanted side-effects of the Basel I and II rules was the explosion in off-balance sheet financing and the use of over-the-counter (OTC) derivatives. The end-result of this trend, aided by a faulty credit rating system, was excess leverage in the banking sector and a severe underestimation of systemic risk.
Now, Draper said, with regulators cracking down on banks’ proprietary risk-taking and over-the-counter derivatives trading, an ETF range might also represent a valuable hedge to banks against possible adverse changes in the rules of the banking game. Having a captive client business that is a big user of the products is a plus, particularly in derivatives.
In possible connection with this, I hear rumours that one leading US investment bank, which is so far only indirectly connected to the European ETF market, is investigating the launch of an ETF range. With the “Volcker rule” suggesting that US banks cut down on their own proprietary risk-taking in favour of client trading, the rationale for expanding the range of clients (including ETFs) that might be derivative counterparties is clear. Even though by one account Volcker’s initial conception was heavily watered down by the time the Dodd-Frank bill was passed last month, banks can see which way the wind is blowing.
Those of us who are focussing on the size of issuers’ ETF ranges in determining their viability are missing the point, in other words. Barriers to entry are low, according to Credit Suisse, while exiting the market would pose a risk to a bank’s reputation. And since ETFs overlap so closely with banks’ trading and derivatives activities, the broader picture of how the funds fit into a bank’s overall operations may matter more than the ETF division’s own profitability.
ETFs as cheap, relatively transparent index trackers – that’s a familiar story. But ETFs as self-defence by banks – who would have thought it?