On 1 November, db X-trackers held its ‘ETFs under the microscope’ seminar in London. The headline speaker at the event, Manooj Mistry (pictured), head of db X-trackers for the UK, outlined the evolution of index replication from its initial origins of full physical replication to the precision market tracking offered by swap-based ETFs today.
Mistry explained how db X-trackers, by complying with the UCITS framework and implementing other in-house safeguards, ensures that in the case of db X-trackers ETFs, investors are not negatively impacted by potential conflicts of interest that could arise from the same financial institution both sponsoring the ETF and acting as swap provider. db X-trackers makes use of an independent investment manager, custodian, administrator and collateral manager, which are charged with managing the day-to-day operations of the ETF. This includes checking swap valuations and monitoring swap exposures and collateral quality on a daily basis, while an independent auditor also ensures each ETF is meeting its obligations to investors.
In outlining the sources of counterparty risks in ETFs, Mistry explained that for UCITS funds in general there are two main sources of counterparty risk: securities lending and derivatives usage. Neither of these are unique to ETFs. For swap-based ETFs, counterparty risk stems from derivatives usage, while many physical replication ETFs engage in securities lending. Investors in both swap-based and physical replication ETFs therefore typically have to be aware of counterparty risk, and, if they wish to assess that risk in more detail, how transparent the derivatives usage or securities lending arrangements are.
db X-trackers was one of the first swap-based ETF providers to publish full details of swap exposures and collateral positions. Today, daily updated swap exposures as a percentage of net-asset value (NAV) and a detailed breakdown of collateral buckets – to the individual security level and its associated weighting – across the entire db X-trackers ETFs range is available to all online, with information updated on a daily basis. This is a very high level of transparency for the mutual fund industry.
Another important aspect when assessing counterparty risk is whether the ETF provider uses a single swap counterparty or multiple swap counterparties. One benefit of the single swap counterparty model is that the exposure is clear and measurable – in the case of db X-trackers the swap counterparty is always Deutsche Bank, for instance. With a multiple swap counterparty model investors may not know what specific counterparty exposures are.
Mistry also pointed out that because they trade in the secondary market, ETFs have a liquidity buffer to cope with redemptions.
