Today's all-the-things-are-the-same-thing news, sort of, is Bloomberg's report of the tiff between BlackRock's Larry Fink and a guy at "Lyxor," which is the name of SocGen's ETF business and also a good way to make me think of the words "pyramid," "casino," "typo" and now "SocGen" all at the same time, which does not make me want to invest with them. Anyway, the crux of it is this:
So-called synthetic ETFs, offered by firms including Societe Generale’s Lyxor Asset Management and Deutsche Bank AG, introduce a layer of complexity and counterparty risk that investors may not be aware of, Fink said yesterday. Synthetic funds generate returns through derivatives contracts rather than owning underlying securities as traditional ETFs do.
“If you buy a Lyxor product, you’re an unsecured creditor of SocGen,” Fink, who heads the world’s largest asset manager, said at a conference held in New York by Bank of America Corp.’s Merrill Lynch unit. Providers of synthetic ETFs should “tell the investor what they actually are. You’re getting a swap. You’re counterparty to the issuer.”
Lyxor says au contraire mon Fink, physical ETFs are just as bad:
Physical ETFs “expose their holders to undisclosed levels of counterparty risk to typically undisclosed counterparties,” Nizam Hamid, deputy head of Lyxor ETFs, said in an e-mailed response to Fink’s comments. “The unregulated use of securities lending has resulted in meaningful losses in the past.”
True I guess - ETF sponsors make a chunk of their money by lending the pot of stuff that they're invested in. (At BlackRock, 60% of share lending revenues go to the ETF, 40% to BlackRock.) And in imaginable scenarios, the stock that the ETF has loaned out can't be recalled because the shady undisclosed counterparty has gone belly-up. Also, regardless of what BlackRock is up to, there's a pretty good chance that if you own a share of an ETF it has borrowed away from you, maybe multiple times, so you've got that to worry about or not, depending on your propensity to worry.
But then of course all that stock lending is a pretty well collateralized overnight business, so my propensity to worry would be not much.
Fink's point, on the other hand, is that Lyxor's ETFs are just based on swaps with SocGen. Swaps are an OTC business, and can be collateralized or uncollateralized; it's negotiable. If you have a lot of negotiating power, you don't post collateral. If you don't, you post. If you are an ETF sponsor writing a swap with your own ETF business, you are probably in good shape to dictate terms.
Now we are of course 100% in favor of banks getting cheap unsecured funding by selling a thing advertised in big print as replicating an index, while noting in significantly smaller type that it's actually an unsecured instrument of the bank, in the hopes that less sophisticated investors will be unable to price the credit risk and therefore won't charge for it. If you do this right, you not only get underpriced unsecured funding, but you get an earnings boost when everything else is going poorly.
But actually that's not the synthetic ETF business, or not exactly, at least not in Europe. As Bloomberg says:
To protect investors, European rules require that synthetic funds be collateralized to at least 90 percent of the value of net assets. Lyxor typically overcollateralizes its funds.
Indeed! So synthetic ETFs and physical ETFs are the same thing.* In both, you give $100 to a guy and in return he promises you exposure to an index of 50 stocks. If you break into the guy's vaults in the middle of the night, you won't find the 50 stocks. Instead, you'll find a bunch of unrelated collateral: securing the swap in the synthetic case; securing the stock borrow in the physical case. The stocks are elsewhere, doing their thing on their own.
They're not quite the same though. Here's a line from a Lyxor prospectus:
For up to 10% of its net asset value, the Fund will use OTC equity-linked swaps exchanging the value of the Fund's equity assets (or any other financial instrument held as an asset by the fund, where applicable) for the value of the IBEX35 index.
See the difference? The collateral in a physical ETF is cash, typically for 102-105% of the market value of the index, typically reinvested in money market-y things. The collateral in a synthetic ETF is 90+% (usually over 100%) of the market value of the index in - "equity assets (or any other financial instrument ...)." Not, mind you, equity assets reflecting the underlying index. Just whatever SocGen feels like stuffing it with. One assumes that it prefers to stuff its ETFs with things that are hard to fund elsewhere. In other words, the synthetic ETF isn't really unsecured funding, but nor is it overly picky about its security.
As a potential ETF investor, you can see the force of Fink's objections. On the other hand, as a person who is too lazy to invest in ETFs and who wants the world to stay out of dig-a-hole-and-hide mode, I am not all that broken up by SocGen's ability to get funding for its cats and dogs via a $40bn, retail-y ETF business. If you're a client of that business and your money is funding those cats and dogs, well, tant pis, but if what keeps you up at night is the systemic effect of a blowup among the big derivatives-dealing European banks, then their having a big stable captive source of repo funding is not an entirely bad thing.
* US synthetic ETFs don't seem to have to be collateralized; ProShares proudly tells you that "The Fund will be subject to credit risk (i.e., the risk that a counterparty is unwilling or unable to make timely payments to meet its contractual obligations) with respect to the amount it expects to receive from counterparties to derivatives or repurchase agreements entered into by the Fund." On the other hand US synthetic ETFs are typically levered or short so everyone kind of knows they're just a punt anyway.