Lyxor Defends Synthetic ETFs That BlackRock Chief Fink Calls Too ‘Opaque’
Lyxor Asset Management SA, the third-largest provider of exchange-traded funds in Europe, said derivatives-based ETFs, which have been singled out by regulators as needing more transparency, are no riskier than their traditional counterparts.
The so-called synthetic ETFs, which produce returns through derivative contracts rather than by owning underlying securities, have attracted scrutiny over their complexity, counterparty risk and ability to meet sudden, large-scale investor redemptions. BlackRock’s Laurence D. Fink, who runs the world’s biggest asset manager, last week urged U.S. lawmakers to ban synthetic funds from calling themselves exchange-traded funds, saying they’re too “opaque.”
“It is unfair to single out risks in derivatives rather than cash ETFs,” Alain Dubois, chairman of Lyxor, a unit of Societe Generale (GLE) SA in Paris, said in an interview with the Bloomberg Risk newsletter. “The risk profile is exactly the same.”
ETFs typically own baskets of securities tracking a market or industry benchmark, like an index mutual fund, while trading throughout the day on an exchange like a stock. The funds hold about $1.43 trillion in assets worldwide. While synthetic ETFs incur counterparty risk from a derivative’s provider, physical ETFs face a similar risk when they lend out securities, Dubois said.
“The only difference is that you have swaps with bank counterparties on one hand and securities lending with bank counterparties on the other,” he said.
Almost all of New York-based BlackRock’s ETFs are physically backed, meaning they own stocks, bonds or commodities and don’t replicate an index through derivatives.
‘Raise the Dialog’
BlackRock wasn’t singling out derivatives-based ETFs in its call for new rules earlier this month, said Jennifer Grancio, head of global business development for the firm’s iShares unit.
“Where there are potential risks in physical ETFs, as in securities lending, we are committed to raising the level of disclosure and setting the market standard,” Grancio said in an interview. “We are seeking to raise the dialog around ETF reform. Our focus is on setting uniform standards and establishing truth in labeling across all exchange-traded products.”
Lyxor, like Deutsche Bank AG’s db X-trackers, the second- biggest ETF competitor in Europe, provides most of its ETFs in synthetic format. Synthetic ETFs in Europe have shrunk by 14 percent this year after growing faster than their physical rivals in 2010, according to BlackRock data. Physical ETFs in the same market have grown 1.2 percent in 2011.
Counterparty risk refers to the chance that the opposite party in a contract will fail to meet its obligations. For a synthetic ETF, the risk is that its derivative provider will go bankrupt, leaving the fund with no return. For physical funds that lend securities, the danger is that a borrower will collapse and fail to return them.
For Lyxor’s funds, the counterparty is the firm’s parent bank. BlackRock ETFs on average have more than 10 securities- lending counterparties, a diversification that reduces risk, according to the firm.
Of BlackRock’s Dublin-registered ETFs that are allowed to lend securities, the funds have an average of “less than 20 percent” of assets on loan, said Brian Beades, a spokesman. In the U.S., the average is 5 percent to 10 percent, he said.
For both synthetic and physical ETFs, the risks are mitigated through collateral posted by the counterparty. Under European rules, collateral for synthetic ETFs must equal at least 90 percent of net assets.
Synthetic Fund Assets
Lyxor’s ETFs are typically backed by collateral equal to at least 100 percent of assets, according to company data. BlackRock requires collateral equal to 110 percent to 112 percent of the value of any loaned securities.
Synthetic funds account for about 41 percent of ETF assets in Europe. They’re less common in the U.S. The Securities and Exchange Commission has approved derivative-based ETFs only for funds that aim to provide multiple or inverse returns of an index, and suspended new approvals in March 2010, pending an ongoing review. Some commodity-based funds in the U.S. that aren’t regulated by the SEC use futures contracts to track an index.
Synthetic ETFs are typically cheaper than those using physical replication and often provide returns closer to the index, especially in less liquid markets.
Using derivatives rather than buying the physical assets adds a layer of complexity and risk that BlackRock has argued requires clearer labeling, better disclosure of holdings including collateral, collateral standards and counterparty diversification.
The U.K. Financial Services Authority raised concerns in a June report about counterparty and collateral risk posed by synthetic ETFs. The International Monetary Fund and the Bank for International Settlements also have issued reports examining whether synthetic ETFs could present a systemic risk because of reduced liquidity of collateral during a market crisis.
IShares, acquired in BlackRock’s December 2009 purchase of Barclays Global Investors, had $548 billion in assets as of Sept. 30, or 38 percent of the global market. Db x-trackers managed $45 billion and Lyxor $38 billion.
Worldwide ETF assets, including exchange-traded notes and trusts, have grown about 18-fold since 2000, according to BlackRock data.
“As ETFs have grown -- no different than we saw in the mortgage market in the ’80s and then in the ’90s and in this decade -- a simple product morphed into something that was very complex and risks were contained in these products that maybe investors did not know,” BlackRock CEO Fink said in an Oct. 19 earnings call.