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Europe leads the way in synthetic ETFs


Between 2006 and 2010, Europe had the highest levels of synthetic ETF issuance (90 per cent) compared to the US and the rest of the world, according to a new Celent report – Synthetic Exchange-Traded Funds in Europe: Getting Ready for Reform.

The exchange-traded funds market has been growing globally in the last decade, with the exception of 2008, due to the financial crisis. The market has evolved differently in different leading markets such as those in the US, Europe, and Asia.
Equity has been the main asset class with regard to ETF assets under management (AuM) globally. In the last year, the AuM for fixed income has been rivaled by commodities, because the latter is being sought as a shelter against the turbulent economic conditions globally.
In Europe, equity has again been the leading asset class for ETF AuM. However, unlike the global market, commodities are the second most important asset class as the European market deals with the recent debt crisis.
As mentioned earlier, the evolution of the European ETF market has been quite different from its US and Asian counterparts. In the US, as a result of the various regulations, physical ETFs are preferred to synthetic ETFs. However, in the European market, the UCITS regulations have permitted greater freedom for the operation of synthetic ETFs.
Europe is the leading global market for synthetic ETFs. For example, between 2006 and 2010, Europe has seen the highest levels of synthetic ETF issuance compared to the US and the rest of the world. Almost 90% of the issuance of synthetic ETFs in 2010 occurred in Europe.
An important issue with synthetic ETFs in Europe is that, for a number of the ETF providers affiliated to leading European banks, there is higher risk due to the use of possibly illiquid collateral being provided by the affiliated bank. This can lead to a higher level of counterparty and systemic risk in the economy.
In terms of the cost of managing an ETF, synthetic ETFs seem to be cheaper than their physical counterparts, especially in Europe. The lower cost is also due to the use of collateral available with affiliated banks by the asset managers.
Another issue with the collateral management for synthetic ETFs is that the composition of the collateral can be very different from the composition of the underlying index that is supposed to be replicated. This is not always a problem, but in the case of a crisis or a high level of redemption, this difference might lead to higher counterparty risk than anticipated.
Some of the leading global regulators are looking at the impact of synthetic ETFs on levels of counterparty and systemic risk. In Europe, the European Securities and Markets Authority (ESMA) has voiced concern about this issue in the recent past. ESMA is expected to provide new guidelines for the asset management industry with regard to synthetic ETFs in 2012.
The volatility in the market, concerns for counterparty risk, and regulatory pressures have together meant that the volumes of inflows for synthetic ETFs have declined for most of the leading players in the industry in Europe. This is partly due to the regulatory uncertainty as well, and once ESMA has produced its new guidelines in 2012, the volumes in synthetic ETFs might increase or decline, depending on how stringent the new rules are.
The European ETF market has grown steadily between 2005-2011. The share of the synthetic ETF market has also grown over this period, rising from around 21% in 2005 to more than 45% of the value of the overall European ETF market in 2011.

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