So far so vanilla. Now lets look at how, as the ETF market has grown, the clever boys and girls of finance have found ‘innovative’ ways of pumping those ETFs up a bit, just like they did to Securities.
Use of Derivatives in ‘Synthetic’ ETFs
The main innovation in ETFs has been the creation of what are called ‘synthetic’ ETFs which instead of actually buying or even borrowing a basket of shares, use derivatives to track the value of the underlying market without the need to match its composition. Instead the Synthetic ETF enters into an asset swap agreement with a counterparty using an over-the-counter (OTC) Derivative. Before explaining what the heck that means let’s just look at how quickly the Synthetic market has grown.
Synthetic ETFs have grown very rapidly in Europe and in Asia. In Europe Synthetic ETFs are now 45% of the over all ETF market. Synthetics doubled their market share between 08 and 09.
The key to Synthetics is the Counterparty. What happens is the ETF Sponsor designs the deal, the AP (Apporved Participant. Usually one of the big banks or brokers) buys the basket of assets to make it, but then swaps that basket with the Counterparty for a different basket of assets in a derivative swap deal. However it turns out that rather too often for comfort, not only will the Sponsor and the AP be the same bank, but more often than not it will be the Asset Management branch of the same bank who will be the Swap Counter-party as well. It is quite common for the same bank to play all three roles. So a single bank creates the ETF, appoints itself as AP so it can fund it and then its Asset Management desk becomes the derivative counterparty in order to mutate the whole thing into a synthetic ETF. Think about what this does to the risk. What was market risk, where the risk was spread out across all the different shares, is now a single counterparty risk. The bank has effectively put all the ETF’s risk in one basket – itself.
But even if it is a different bank acting as the derivative counterparty the situation is only very slightly less incestuous because it is nearly always the case that the Sponsor, AP and Counter-party will all be from the same small group of big banks, brokers and Asset Managers. And it is also a statistical fact that all of them will be counterparties with each other many, many times over, via the over $1.2 Quadrillion of other repo, rehypothecation and derivative deals. This, as the Financial Stability Board’s report on instabilities in the ETF market rather laconically puts it,
…may also generate new types of risks, linked to the complexity and relative opacity of the newest breed of ETFs. The impact of such innovations on market liquidity and on financial institutions servicing the management of the fund is not yet fully understood by market participants, especially during episodes of acute market stress.
Not fully understood? I think we may not have understood what such entanglements of reciprocal risk meant before the first period of ‘acute market stress’, but I think now it is nutty to imagine the banks don’t know how risky such risk incest really is. The FSB report itself concludes,
Since the swap counterparty is typically the bank also acting as ETF provider, investors may be exposed if the bank defaults. Therefore, problems at those banks that are most active in swap-based ETFs may constitute a powerful source of contagion and systemic risk.(P.4)
Please step forward Deutsche Bank and Soc Gen!
A “powerful source of contagion and systemic risk”. Sounds really good for you and me. So why are the banks doing it anyway? The official answer is that using Derivatives means the ETF can track the value of the market more closely. Though few have complained that Vanilla ETFs don’t track closely enough. And as the BIS report points out,
…the lower tracking error risk comes at the cost of increased counterparty risk to the swap provider. (P.8)
But this doesn’t answer why a bank would enter into a swap with itself as the counterparty. The whole idea of counterparties, once upon a time, was to hedge some of the risk in the original deal by passing it off to someone else. Using yourself as counterparty keeps the risk in-house. So once again why?
The answer is, according to the BIS report on ETFs,
…that this structure exploits synergies between banks’ collateral management practices and the funding of their warehoused securities. (P.5)
‘Synergies’ sounds like it should be good. Sadly it may not be. As the BIS goes on to explain,
…synergies arise from the market-making activities of investment banking, which usually require maintaining a large inventory of stocks and bonds …. When these stocks and bonds are less liquid, they will have to be funded either in the unsecured markets or in repo markets with deep haircuts. (P.8)
In essence it costs the banks money to have illiquid assets on their books. The repo markets won’t accept them as collateral unless they come with a deep haircut. So the banks can do little with them except sit on them. Basically it costs the bank to have the illiquid, hard to sell or Repo, stocks on its books. But.. .if they happen to have created a handy synthetic ETF, then everything changes because,
For example, there could be incentives to post illiquid securities as collateral assets [in the ETF Swap]…. By posting them as collateral assets to the ETF sponsor in a swap transaction, the investment bank division can effectively fund these assets at zero cost….
Handy isn’t it? Assets they can’t repo without hefty haircuts can be posted as collateral to their own ETF with the approval of the ETF Sponsor of course – who will just happen to be… the same bank – without those pesky, hurtful haircuts. In fact,
The cost savings accruing to the investment banking activities can be directly linked to the quality of the collateral assets transferred to the ETF sponsor.
The worse they are, the more illiquid, the more the bank saves/makes by choosing to put them in an ETF rather than having them loiter on its books.
…the synthetic ETF creation process may be driven by the possibility for the bank to raise funding against an illiquid portfolio that cannot otherwise be financed in the repo market. (FSB report P.4)
This is surely financial innovation at its shining best.
Now of course the banks will say they would never consider slipping some old tat into their ETF under cover of opacity. Except that they did, every one of them, do exactly that when they systematically and grossly lied about every single aspect of hundreds of billions worth of shabby mortgages which they intentionally stuffed into CDOs in order to shaft and rob those they sold them to. This is a matter of public record. The 522 pages of the Class Action suit against Citi which Citi lost ,makes truly shocking reading. The same people, under the same management, with the same world view, same assumptions and same prejudices, looking for the same profits, to gain the same bonuses will do the same with ETFs as they did with CDOs. The bubble will incubate inflated prices and effervescent greed until the top of the market is reached, which will signal the turn to more and more deceitful practices done in the name of keeping it all going so as to avoid a crash. Until that is, the crash comes anyway, as it will, and everyone claims not to have known or even suspected.
There are, of course, a few inadequate rules convering some aspects of this rather obvious entry point for fraud. The collateral provided by the counterparty has to cover 90% of the value of the ETF. So at least if it did all go awry there should only be a 10% loss. Of course who decides how much the collateral is actually worth? Another entry point for fraud. The types of collateral are limited to cash, equities (shares) and government bonds of OECD countries. Yikes! I wonder how many European synthetic ETFs are stuffed with Spanish and Italian sovereign bonds held at full value with a risk weighting of zero? I leave you to guess.
Now another wrinkle on this is that when equities are posted as collateral they are given some sort of ‘haircut’. This can be as high as 20% as is the case in Ireland. This is done so that the ETF sponsor can say that the ETF is super safe because it is ‘over-capitalized’ by 20%. However in Luxembourg the haircut doesn’t have to be 20%. The amount is negotiated between the Fund Custodian and the Fund Management Company. Except we already know they can be the same company. And even if they are not, the relationship between Management and Custodian is notoriously incestuous. The Custodians rely on the Management companies to bring them work. Who bites the hand that feeds them? They didn’t when they were Custodians of fraudulent CDOs.
So Ireland 20% haircuts, Luxembourg negotiable. Guess in which country most synthetic ETFs are registered? The moment you hear that Ireland is reconsidering the 20% haircut in order to compete with Luxembourg you’ll know we have reached Fraud Con 2 . But then you lean back from the keyboard and think – Am I really feeling relieved that Ireland is the alternative to Luxembourg? Let’s face it on the evidence of the last 4 years I would have to say that if you drew the Irish regulator a map, gave him directions and a torch, and left a trail of bread crumbs he still wouldn’t be able to find his own arse.
Anyway I digress.
I should also mention that all the CDOs ever made were subject to rules about over-collateralization. It didn’t save any of them. The over-collateralization turned out to be largely a function/fiction of over-optimistic bubble prices which went massively negative as soon as the crisis started. As the BIS report says of the collapse of CDOs,
Despite the overcollateralization enforced by credit agencies when rating these products, embedded leverage and market risks were materially higher than those modelled. As the unmodeled market and liquidity risks of these products materialised, it led to fire sales that subsequently triggered a broad-based deleveraging process in the financial markets. (P. 11)
The same dynamic of over-pricing followed by price collapse would undoubtedly be true of ETFs as well. There are few sound reasons to think otherwise.
Dodgy as all this may sound the ‘Death Zone” as mountaineers call it, is still ahead of us as we ascend Mount Finance. Above the tree line of Synthetic ETFs are the Leveraged, Inverse and Leveraged Inverse ETFs. They all use increasingly complex and opaque derivatives contracts to achieve multiples of the rise or fall in value of the market being modelled. These synthetic ETFs offer double and triple gains but with the risk of double and triple losses. What is often not understood is that because these funds are calculated daily if you are foolish enough to leave your money in there for more than a few hours, you will almost certainly lose no matter which way the market moves. Plus it doesn’t take a genius to see that such funds, when a crisis of confidence hits, could easily trigger a stampede to withdraw which could in turn force the banks to sell some of the illiquid assets they put into the ETF which would depress the prices of those assets and rattle the market as to their value and the solvency of those holding them but needing to sell them quick.
Higher up still, where the oxygen of common sense is too thin to support sentient life, beyond even leveraged ETFs, there are now a range of yet more exotic ETF-like products often referred to collectively as ETPs (Exchange Traded Products). ETNs (Exchange Traded Notes) and ETVs (Exchange Traded Vehicles) are in fact not funds at all. They are debt based products. They are so removed from any notion of tracking a market that the name is almost misleading. Why invent them? Well for one thing they are not subject to some of the requirements which apply to Funds, such as rules covering the diversity of the assets they are based on. Some don’t require collateral behind them at all, just the good standing of the issuer (Usually a bank). ETNs are a debt instrument issued by and backed by the financial institution ‘Sponsoring’ the ETN. As such the risk is entirely based on the rating and solvency of the issuer.
ETVs are similar to ETNs but the debt is not even issued by a bank directly but by an SPV – an arm’s length company created to contain any losses. As such they add even more counterparty risk. You have to marvel at how quickly all these products, so ominously familiar from the first leg of the crash, have been re-invented in their new guises.
At this point you might be thinking that the problem boils down to those crazy Europeans with their inexplicable death-wish love for synthetic rubbish. While I agree with that view of European Banking I do have to point out that while the Europeans are indeed going to shoot themselves in the head with derivatives the Americans are going to garrote themselves with ‘Securities Lending’.
Securities Lending is the practice of taking the securities from one product/place and lending them out to someone else for them to use in some other product/place. We all do it. You put money in your bank but ‘allow’ the bank to lend it out. In effect your money is supposed to be ‘in’ your account belonging to you, but is in fact in Aberdeen being used by a brewer to make more beer and he thinks the money now ‘belongs’ to him. Same money, two places, two ‘owners’. Securities lending does the same thing on a global scale with securities. Securities owned by banks, Pension funds, and in fact every kind of fund including ETFs all lend out their securities (shares etc)….to each other. Don’t worry – they’re all good for it.
Such lending is the basis of how shorting is done. Hedge funds rely on it. And now there has been a huge increase in securities lending in the ETF market. What this means is that the securities which are ‘in’ the basket of assets underpinning the ETF are in fact not in it at all but have been lent out to someone else for them to use. You’ll no doubt recognize this as akin to repo or re-hypothecation. You can read about re-hypothecation and its dangers in “Rumours, disasters and re-hypothecation” and in “Plan B”
According to the FSB report,
Some ETF providers are said to generate more fee income from securities lending than from their traditional management fees. (P.4)
The fact that more money is made from lending-out than from taking care of the shop is a worry. But a greater worry is the compounding of such lending. You see, exactly as is the case in re-hypothecation, once a security has been lent out by an ETF there is nothing – or nothing that can’t be easily gotten around – to stop it being lent out over and over. Each person to whom it is lent out puts it to work as the guarantee of their business but can than also lend it out exactly as it was lent to them, creating long chains of people all of whom have a claim on it but none of whom will own it, when the first person pulls the emergency cord. As with re-hypothecation, in the bubble years securities lending leads to a situation of barely regulated leverage and as the leverage grows so does the systemic risk within the system as a whole.
…the use of ETFs as collateral in a long chain of secured lending and rehypothecation may create operational risks and contribute to the build up of leverage.
Leverage is what our present financial system needs like a junky needs Smack. Now ETFs are feeding that habit.
And now for the final thing I want to raise.
ETFs of all sorts are passive instruments which mean they blindly follow and replicate the ups and downs of whatever market (shares, commodities or bonds) they are following. The idea is that the thousands of decisions of traders in the market will be a robust indicator of ‘real worth and value’ which the ETF ‘efficiently’, but blindly, follows. Fine. But now imagine that the volume of shares and trades in the ETF begins to grow rather large in comparison to the volume of shares and trades in the underlying market. You can imagine a situation where a small number of traders, with a small amount of wisdom between them, is effectively making decisions for a vast number of others who have far greater wealth, but who are just slavishly following the few. At that point we will have an unpside down market where the blind Many follow the worried Few. And the huge buying power of the Many, blind as they are, drowns out the market signals of the few real decision-making traders in the actual market. This will lead to greater volatility as huge volumes of blind trades are triggered by tiny signals from below. You end up with a very large tail, thrashing a small dog. We’re not there yet although I think this may already be beginning to happen with some tech stocks like Apple.
Now, and lastly I promise, add in the fact that ETF shares are themselves traded in the markets the ETFs are following, as are the shares of the banks who run and fund those ETFs. Shares in some of the banks who run the ETF market will be in many ETFs. At what point does the value of the ETFs pump up the value of the bank shares, which pumps up the value of the market the ETF is following which pumps the value of the ETF?
We had this sort of run-away feedback in the market for CDOs just before they exploded.
Couldn’t happen? The average daily volume of trade in options on US ETFs now exceeds those of ALL US stock options combined.
ETFs have in their DNA everything it takes to become monstrously dangerous. They are wide open to all the fraud and shitty behaviour the banks seem not to be able to stop themselves from bathing in. They are awash in leverage and riding on a tide of derivatives which hide so much concentration of counterparty risk that it makes a mockery of ‘risk management’. ETFs are barely regulated by regulators who are massively behind the curve. And the ETF industry is both valuable to those who run it (the Banks) and is gearing up to fight a pre-emptive war with the regulatory authorities.
The ETF industry is just now setting up a new industry association the National Exchange Traded Fund Association NETFA, whose goal “…will be to address misinformation about ETFs, said Adam Patti, the association’s vice chairman.”
And there you have it. You see there is in fact nothing wrong with ETFs at all. They are honest, well regulated, perhaps even over-regulated, transparent, safe havens in an unsafe world. Innovative products where risk has been banished or massaged away by experts, for your benefit not theirs. They are just there to serve you.
All you need to watch out for is misinformation.