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.

I think that in a couple of years, unless something alters the current trends in money flows, we will come to know ETFs the way we already know the securitization and packaging of  sub-prime mortgages into CDOs. I think the signs are already there to suggest ETFs are where the instability and risk is accumulating. If I am in any way correct then ETFs will be to the next stage in our on-going state of siege-mentality crisis what CDOs were to the last.

To substantiate this claim I have to tell you in simplified terms what an ETF is. And then explain how, despite all the differences between mortgage backed CDOs and ETFs, the latter generally being based on stocks, bonds and commodities rather than mortgages, they are undergoing the same evolution from simple to opaque, stable to unstable, are being seen as the provider of liquidity and risk-controlled ‘exposure to risk’, just as CDOs were, when in fact they are concentrating risk and will, in a moment of panic, cause liquidity and lending to collapse.

In any ecosystem there are certain niches: large carnivore, carrion eater, arboreal fruit eater etc. These niches can persist even as the particular species that fill them go extinct. What you find is that another species, from a different family, will evolve into the niche because it is ’empty’ and therefore there is ‘a job’ going free. So it is in the present ecosystem of global finance. In many ways the ETF is evolving, or being bred, to fill the same niche that Securitized debts (CDOs) filled only a few years ago.

Here is how a paper for the Bank for International Settlements (BIS) describes the rise of the ETF.

…in the low global interest rate environment in 2002–03, structured credit products [CDOs] were marketed to gear up investment returns for institutional investors …as they offered higher returns to comparably rated plain vanilla assets.

The financial crisis experience, however, dampened investors’ appetite for structured credit products. Yet the low global interest rates that supported growth in structured credit products have returned, with institutional investors facing similar problems to those back in 2002–03. This time, financial intermediaries have responded by adding some innovative features to existing plain vanilla investment funds.   (P.1)

The ‘same problems’ the BIS mentions are that when interest rates are low banks can’t make much return by simply lending out money. So the desire for a higher return spurs the invention of financial products that promise that special combination of a higher return but without the higher risk that should come with it.  Securitization and CDOs promised it. ETFs promise it.

So what is a basic ETF?

An ETF (Exchange Traded Funds) is an investment fund which holds a mix of stocks, bonds or commodities such that it emulates and thus tracks the over all value and performance of the particular exchange it is based on, such as the Dow or the NASDAQ. So when you buy a share in an ETF you are buying, as it were, a tiny, representative slice of all the stocks and shares, bonds or commodities which characterize the whole market.  Just as a mortgage security and CDO was a way of buying a little slice of a pool of mortgages, so an ETF is made of ‘slices’ of a basket of shares, bonds or commodities depending on the kind of ETF. In both cases the ‘product’ is marketed as a way of investing in a basket of stuff so as to spread the risk that comes with buying all of one thing. Of course as soon as something is understood as a way of  spreading or lessening the risk it is immediately seen as a way of ‘getting exposure’ to more risky things  – in a less risky way of course. A less risky way of taking risks – the claim of modern financial innovation boiled down to its essence.  So ETFs are marketed as a way of investing in less accessible and more ‘risky’ markets via a product that ‘smooths out’ the risks for you.  To me these are the obvious parallels between securities/CDOs and ETFs, on the ‘risk’ side.

There are also parallels on the ‘liquidity’ side. As a recent paper by the Financial Stability Board (FSB) on ETFs says,

… their main advantage is to combine the low-cost diversification benefits of index-linked and basket products with the high liquidity and tradability of individual stocks.

What makes ETFs different from other kinds of investment funds, like Money Market Funds, is that shares in the ETF can be bought and sold like any other stock or share, on a second by second basis. Whereas Money Market Funds are redeemable and valued only once a day. Money Market funds are sometimes characterized, especially by those offering ETFs, as large, conservative and slow creatures. The herbivores of the financial world. Whereas ETFs are seen as faster and more responsive, combining the basket nature of a fund but with the instant tradability of stocks.

ETFs are also seen as increasing and therefore providing liquidity not only to the buyers in a market but to the sellers as well. Some of the biggest ETFs are based, in part at least, on shares from emerging markets which many investors would not know much about or dare to purchase. As the BIS paper says,

Investors’ desire to seek higher returns by taking exposure to less liquid emerging market equities and other assets through ETFs that guarantee market liquidity…. (P.1)

Thus an ETF listed and trading in NY may contain shares in Korean companies. Suddenly those more obscure Korean stocks are moving in NY.  So ETFs claim to provide liquidity for buyers and sellers – the whole market. Good for you, good for me – good for everyone.

So that is a very simple sketch of ETFs and some of the claims made for them. The important point for me is how ETFs are in many ways slipping in to the niche left vacant by Securitized products like CDOs. Same sorts of claims about safety versus risk, and about providing liquidity. ETFs and those who run them are, it seems to me, positioning themselves as not only good and safe, but by being liquidity providers being also systemically important for the health of the broader market. Sound familiar at all?

Their growth.

ETFs were  invented back in the 90’s. The first ETF was on the Toronto exchange in 1989. It was 1993 when the first ETF appeared in America. By 2002 there were 246 around the globe. They continued to grow but  so long as the securitized, mortgage backed CDOs reigned supreme the ETF was its poor relation. With the collapse in demand for securitized, mortgage-backed products, the ETF, I think, is poised to emerge as the successor.  In 2005 ETFs held a mere $410 billion in Assets Under Management (AUM). Enter the crash and the heart-attack contraction in Securitization, and by 2010 ETFs had tripled to $1.3 Trillion Assets Under Management and are growing.

Large as this sounds it is worth keeping in mind that the ETF market is actually still small, just 5% compared to the much more established Mutual Fund market. But we are still in the early days of the rise of the ETF. The equivalent, I would guess, of where Mortgage backed securities and CDOs were in 2002 or earlier. It is the rate of growth, not its size which seems to me to tell the story. The ETF industry has grown at 40% a year over the past 10 years! The broader market has achieved 5%.

ETFs are big, getting bigger and are everywhere in every market tracking every sort of asset from simple stocks, to corporate and sovereign debt and commodities from gold and oil to wheat and soya. According to the FSB paper from which I’ve already quoted (P.2) at the end of  2010 there were 2500 ETFs offered by 130 companies, traded on over 40 exchanges.

Now before I start on what I consider to be the dangers I want to make it clear that I don’t think ETFs are necessarily a bad thing. But just as with Securitization they can become a very bad thing. I also don’t think disaster is upon us with ETFs. But I do think they we can see signs that they are a possible, even likely venue for the same unwise, unsafe, unstable accumulation of ignored risk and systemic instability.

Reasons not to be cheerful.

So here is a brief and necessarily incomplete look at some of the reasons I think ETFs are becoming dangerous.  Disclaimer – I am not an expert in ETFs. As with everything I write it as an educated person who has read what he can find and has tried to think clearly about what he has read. Nothing more.

When ETFs began they were what is now referred to as plain vanilla or physical ETFs. Such ETFs replicate the broader market by simply buying a representative basket of the shares which make up the market . The ETF’s creator/Sponsor gives this basket a company name and then creates and sells shares in that name, which people can buy and sell. So the ETF owns shares of all sorts of companies in the market. You do not – not directly. You buy and own shares in the ETF. Please note, because it will become critical later, that there are two markets and two sets of shares which the ETF sits across. The ‘primary market’ as its known is populated by ‘Authorized Participants’ which for the vast bulk of ETFs are the small club of global banks and brokers we have all heard so much about in the last few years. They buy or borrow (often from Pension Funds) the stocks and shares which will make up the ‘basket’ which they then put into a Trust. That Trust is then the issuer of the ETF. The Trust then creates what are called ‘Creation Units’, which are blocks of tens of thousand of individual shares in the ETF, which it gives back to the Authorized Participant.  The Authorized Participant then either keep these shares as an investment for themselves or sell them on the ordinary , or as they call it, the ‘secondary market’ to ordinary buyers who wants to own an ETF share.

A couple of points to note. The shares in the Trust which issues the ETF shares are very often borrowed from Pension Funds who are and remain the actual owner of the shares. The ETF shares issued against the ‘borrowed shares held in the Trust’ therefore do not confer actual ownership of the underlying shares so much as a ‘legal claim’ upon them. You can read more on this line in this paper from NASDAQ. You may wonder why ETFs have this complicated double layer of shares – those it borrows or buys to make the basket and those it then issues to investors – and the reason is tax. No cash is being exchanged, it is all shares for shares at every step. This means there is no tax  to be paid on any of the transactions.

However this tax efficient structure – which is the essence of the ETFs advantage over Mutual funds, presents what I think is the first overlooked problem.

Pinch Points in the ETF markets

Above I noted that as of the end of 2010 there were 2500 ETFs offered/sponsored by 130 companies, traded on over 40 exchanges. Which sounds like a healthy, broad based, liquid market. The Sponsor is the company that starts the whole thing, when it puts forward the plan for an ETF, gets that plan approved and manages it. However look a little closer and you find only 6 companies Sponsor and control  80% of the market.  Or to put it another way 80% of the market in ETFs globally, relies on the health and solvency of just 6 companies. Not a wide base then.But it gets worse.

Here is a list of the big 6 ETF sponsors and who owns them.

i Shares                                          = Blackrock. No 1 in ETF world with $670 B Assets Under Management (AUM).

State Street Global Advisors    = State Street Bank and Trust. $2 T  AUM. No 2 ETF with $283 B in ETF assets.

Vanguard                                      = Specialist ETF company based on Pennsylvania.No 3 ETF. $204 B

Lyxor Asset Management         = Soc Gen. with €85 B AUM in 1688 funds

db x-trackers                                 = Deutsche Bank

Powershares                                  = Invesco. A US company HQ in Atlanta but incorporated in Bermuda.

So of the 6 companies who are most of the ETF market  two are drawn from the ranks of the Global banks which have had to be bailed out.

However the Sponsors are not alone. The Sponsors rely for the heavy lifting of buying and selling the shares – market making in other words – on the Approved Participants to buy/borrow the stocks. Sadly, from the point of view of widening the risk base of the ETF markets, the Approved Participant are drawn from the same short list of global banks and brokers as are the Sponsors.

Here, for example, is a list of APs for an ETF called ‘Greater China’ run by State Street Global Advisors who are the second largest ETF manager in the world:

So 80% of the ETF market relies on the solvency of only 6 companies who sponsor and manage them. They rely in turn on the handful of Global banks whose solvency and stability we already know was in a crisis, and still largely is,  and remain totally dependant on Tax payer bail outs.

So how much stability do the APs bring to the ETF market? Well do you remember the ‘Flash Crash’ back in May last year when global markets suddenly experienced a crash in values that was caused by computer driven, High Frequency Trading? A study done by an ETF analyst revealed that 70% of the securities whose trades were cancelled that day were ETF shares. 70%! The study concluded that reason the ETFs froze and in doing so froze the markets was because the Approved Participants (the club of Global Banks and Brokers) froze. As the analyst said,

If those parties [the APs] are going to be paralyzed in the face of adversity, then the product [ETF] suppliers will have to qualify every statement they make regarding the liquidity and price efficiency of ETFs.

The article went on to point out,

Which, in other words, means the ‘flash crash’ may have shown ETFs to be particularly vulnerable in the event large sell-offs and liquidity lapses precisely because of their  structure’s dependence on market makers and authorised participants.

Precisely! A huge market reliant upon  6 sponsor companies who in turn depend for liquidity in their market, upon a just a handful of the same old banks and brokers, half of whom are themselves chronically insolvent bail out merchants. Now to be fair there are a larger number of other companies who also act as market makers in the sense of being very active traders but who are not APs and therefore do not contribute to the critical actual initial buying of shares to create the ETFs. Nevertheless they do contribute to the liquidity of minute to minute trading – not that they helped at all in the flash crash. So who are they, that we might find some comfort from them? You can find a list of UK market makers here. It contains 28 names. 15 are … the same large bailed out banks: Bank of America/Merrill Lynch, Barclays Capital, Commerzbank, Credit Suisse, Goldman Sachs, HSBC, JP Morgan, Morgan Stanley, Nomura, Rabobank, RBS, Societe General, UBS and UniCredit.

Just like the Securitized mortgage/CDO market before it, the ETF market is constantly folded back on itself so that it relies always upon the same few players. At every stage the health, liquidity and operation of the ETF market is tied to the same very small number of very large players. And the flash crash clearly demonstrates how fragile and thin their liquidity providing and risk absorbtion actually is.

This theme of how everything is constantly tied back to the same players is what I will return to in part two, because it gets so very much worse. So far all we’ve really looked at are  just the general weaknesses of the plain vanilla market.

In the next part we will look at the huge rise in what are called ‘synthetic’ ETFs which are based not on owning shares but on derivative swaps contracts. We’ll look at who the counterparties are of all those derivative contracts. I’ll give you one guess.

Then we’ll look at how those risks have been increased by the creation of ‘Leveraged ETFs’ which promise 2 or 3 times the possible returns but at the cost of doubling or tripling the risks as well.

Then, in case anyone thinks that the Vanilla/Physical ETFs, based on owning the underlying shares, are, by comparison with Synthetic ETFs, not really a problem, we’ll look at how the physically-based Vanilla ETFs increasingly lend out the shares they ‘own’ in order to make more money.

Every European bank exposed to Irish loans, every bond holder holding Irish debt – both bank and sovereign, and every foreign central bank concerned for the solvency of its own banks will start to crank up a barrage of propaganda and threats.  It will be top of everyone’s propaganda agenda to make sure the Irish election offers no choices that could destabilize the unexploded ordinance of European bank insolvency.

The European financial class will be desperate to ensure that the Irish have an election that is carefully constrained so as not to offer anything that might actually help them. As far as the banks, the ECB and all the leaders of nations whose banks would suffer losses if Ireland were to default or restructure, the Irish people are NOT to be exposed to ideas of default.

All parties must be told,  and if that fails to convince, made to feel directly via the bond market, the consequences of any alteration of the course followed so far. And, of course, it has already started. Here   is what senior ECB banker, Lorenzo Bini-Smaghi, said on January 15th regarding Ireland’s electoral choices.

“It would be dramatic for Ireland if just by changing government you renege on the promises that Ireland as a sovereign has made.”

Not that he would dream of making veiled threats to try to frighten Irish public opinion into choosing what would be best for the banks over what would be best for the Irish people.

No mention of Iceland there. Funny that.

The foreign press will run story after story about the dangers of ‘contagion’, of the need for responsibility and resolve.  The Irish Central bank will step in to make grave pronouncements if the political parties seem not to be holding the line.

Foreign leaders such as , Merkel, Olli Rehn, Barosso, Trichet and our British clowns, all with their own national interest, will give talks and be quoted in their papers about the need for steady fiscal responsibility and the unthinkable consequences of any waivering.

If there is any rumbling of popular discontent, then scape goats will be found – people upon whom some anger can be harmlessly vented.  But if that does not work then the rhetoric will get more pointed. Ireland will be reminded that ‘it’s their fault’ and they ‘have no one to blame but themselves’.  In the German press any hint that Ireland may be thinking of restructuring will be met with dark reminders of how ‘Ireland’ in the form of Depfa had to be bailed out by Germany.

In short I don’t think the Financial class is pleased that the politically unreliable (when it comes to European questions) Irish are going to have an election at this delicate time.  I think the run up to the elections will involve a lot of propaganda designed to shout down any opposition to bail outs and debt payments.

So I thought this might be a good moment to get a few things on record regarding Depfa, HRE (Hypo Real Estate) and the banking crisis blame-game.

For those who aren’t already familiar with the Depfa and HRE story, here it is in a very small nut shell.  Hypo Real Estate was the huge German bank which we were all suddenly told, back in 2008, had to be bailed out by the German State at vast cost. But, they said, they had no choice, because Hypo (HRE) was so large and its debts so huge that if it collapsed it would, at the very least, bring down German banking.  It was Europe’s AIG – to big to be allowed to fail. Then the back story emerged.  HRE had bought ‘Irish’ bank Depfa at the top of the market at almost the same time as RBS bought ABN Ambro.  Both purchases were insane and both killed the purchasing bank.

It was then put about that the collapse of HRE was in fact due to a huge funding crisis at Depfa always referred to as ‘its Irish subsidiary’.  From that came the notion that Depfa must have hidden its true state from HRE. Why else would HRE have bought a bank which couldn’t fund itself?

And that is how the story firmed up.  Irish Depfa must have lied about its true state in an effort to sell itself to Hypo, so that when Depfa’s hidden financial problems surfaced, the cost of them killed Hypo and then fell upon the German rather than the Irish tax payer.

It is sometimes easy to forget with all the sordid and ruinous business of Anglo Irish, that the beginning of the whole crisis in Ireland and in Europe was intimately tied to Depfa and HRE. Thus I think it is worth reminding ourselves of some of the misinformation and perhaps offering a few less well known facts. Facts which might help the Irish defend themselves.

It was often said, particularly in the German press, that Depfa ‘brought down HRE’. Had HRE not bought Depfa when it did in 2007, then it would have been the Irish, who had incubated the problem, who would have had to pay for it, not the Germans. There is always this undertone that somehow Depfa must have lied to or misled HRE.

Was DEPFA really an Irish Bank which the Irish should have bailed out?

Less than 1% of Depfa’s business was Irish. Virtually no Irish Banking money flowed into Depfa or its deals.  Depfa was not a major employer in Ireland. A couple of hundred jobs at most.  Few of its senior positions were held by Irish people. Thus in purely bloodless financial terms there was virtually no reason for Ireland to bail out Depfa. Depfa was not systemically important to Ireland or the rest of its banking sector. Depfa was, however, vital to the continued health of the German banking sector.  Add to this that the size of any bail out of Depfa was quite beyond what Ireland as a nation could have done. Ireland’s total IMF bailout stands at €85 billion. All on its own the HRE/Depfa bail out has already cost Merkel well over €100billion. Depfa, like one or two other banks in Ireland, was simply too big for its host. It was a financial cuckoo in the nest.

The German’s, however, would have bailed out Depfa even if it had not been bought by HRE because Depfa’s failure would have crippled something essential to the entire German banking sector – the Pfandbrief business.  The Pfandbrief is a German ‘covered bond’.  A covered bond is simply a super safe kind of bond. It is considered as safe as Sovereign bonds but gives a higher return. Germany invented the Pfandbrief and its banks relied on it.

The Pfandbrief/covered bond is considered super safe because, unlike other bonds, the Pfandbrief is backed by a ring-fenced set of assets which cover the total value of the Pfandbrief/bond. So even if the bank issuing the Pfandbrief were to go under, the Pfandbriefs themselves would never default.  And it has been the bed-rock of the Pfandbrief’s reputation that in 250 years no Pfandbrief has ever defaulted.

At the time of the Depfa bail out there were €806 Billion in Pfandbrief outstanding. The third largest chunk of the German bond market and the section that had been growing rapidly and which everyone wanted to be a part of. The German banking sector wanted to grow and compete with the British and the Americans on the international stage. They saw the Pfandbrief as an important part of their strategy. This article from 1999 gives a great feel for how the markets were then, as they stood on the cusp bubble years.

If Depfa had gone down, it would have taken the AAA rated dependability of the Pfandbrief with it.  Ireland could let that happen, Germany could not. That is why, I think, Germany would have bailed out Depfa no matter who owned it.

Why did Depfa move to Ireland if it was still a ‘German’ bank?

Depfa was always a German bank, that had simply chosen to locate itself in Ireland for funding and regulatory reasons. Does this mean that Ireland was stealing Germany’s banking sector?  No.  The best way to think of Ireland is as German’s off-shore tax haven banking centre with one significant feature – it was within the Euro zone.  Every country has one.  The UK has many. Germany needed one and Ireland was happy to oblige.  Thus it suited Germany as much as it did Ireland. It was a partnership.

Of course Ireland made itself everyone’s honey. But I think it is fair to say that of her many customers she had a special relationship with Germany. Think about it. Depfa, HRE and HVB (Now UniCredit), Deutsche Bank, LBBW, DZ bank, Commerzbank, Bankgesellschaft Berlin, Landesbank Sachsen, WestLB all gravitated to Dublin.

The fact that this arrangement/partnership has fallen apart in acrimony doesn’t alter the fact that when the money was flowing the Germany banks, German bankers and all their politicians were every happy with what was going on in their Irish subsidiary. Ireland does not owe Germany an apology.

In fact I think Ireland should be asking Germany some hard questions over the sometimes abusive relationship German banks have had, and some still have, with Ireland.  See here for how WestLB after it collapsed created an SPV called Phoenix, as a means for parking/dumping €23 billion of toxic ‘assets’ in Ireland.   This, it seems to me, is the Toxic Debt Wasteland I wrote about, becoming real.

How did the Irish Funding work?

Depfa had always raised its cash through its own Pfandbrief bank. It’s source of funding were the Landesbanks who in turn got the cash from the bottom of Germany’s banking system the Kasse, deposit banks.  They had all the cash.

But there were limiting factors. German money was the spur to Depfa’s early growth but the bank, according to a former board member I have spoken to, wanted more.  They wanted better access to international funding and international customers. Neither, as more than one German banker has told me, was readily available in Germany.

Ireland made itself a meeting place for those with money in need of investing and those looking for loans.  For Depfa in particular it was an attractive place. Depfa had decided to target Russian and East European public investments (investing in publicly funded works) and Ireland had made itself attractive to Russian and Eastern money. Money in various shades of shadiness flowed to Ireland.  The timeline of German banks and for that matter all European banks (thinking of UniCredit here) going to Ireland runs parallel to East European and later Russian money beginning to flood out of the former soviet states looking for a new home in the West.  Ireland met that need.  Ireland become THE favourite investment destination for Russian money.

Money was placed in the East. There were and are plenty of subsidiaries there who could pass it along to be funneled westward through Austria (Bank Austria) or Cyprus onward to Ireland where it could find its way to the heart of European banking in Ireland.

Depfa set up a brand new bank Depfa ACS bank, specifically to tap into all this new money.  It even got the Irish parliament, in agreement with the European authorities and German banking sector, to write a new law making it possible.  Ireland created its own version of the Pfandbrief – the Asset Backed Security. This allowed lots of new money to join with the steady flow of Germany money from the Landesbanks to unite in Ireland to the benefit of Ireland AND Germany.

Of course Europe has access to all sorts of Off Shore Banking so what made Ireland special? Ireland was physically close, was already a corporate centre, was English speaking (good for the Americans), was low tax, used English Law (good for London) and had the same ‘we can do if for you’ attitude of Luxembourg.  What gave Ireland the edge over Luxembourg was it offered faster turn arounds on setting up deals and far more lax regulation.  Ireland was perfect.

Ireland and Luxembourg are banking competitors.  But Luxembourg is not English speaking, is slower and worst of all has a regulator who occasionally regulates. The Luxembourg regulator has all his own teeth. Ireland’s had his removed along with his balls a long time ago.

As long ago as 2005, Charlie McCreevy, Ireland’s former Minister of Finance, (another Fianna Fáil man who was at the Ministry of Finance before Brian Cowen took over that job and showed everyone how it should really be done!)  who then became European Commissioner for Internal Market and Services (nothing like failing at one job  in order to get a better job…) addressed an esteemed EU/UN gathering in New York in 2005 in which he famously stated

“As Finance Minister in Ireland I saw what great entrepreneurial energies that a “light touch” regulatory system can unleash. 25 years ago we were the sick man of Europe. Today we are among the richest countries in Europe. Ireland is indeed testimony to the fact that you don’t need to be rich in natural resources to generate real wealth.”

That was shortly before someone shouted ICEBERG!

For those of you whose German is better than mine you will enjoy this German television (ZDF) expose of German Banking in Ireland and Depfa/HRE in particular.  Apart for revealing interviews with senior people in the German banking world, it also contains a brief interview with David McWilliams who famously referred to the fact that the German bankers behaved in Ireland “like men in a brothel” – with the blind eye of the Irish Financial Regulator seeing no evil. WhistleblowerIRL’s roller coaster experience as UniCredit Ireland’s risk manager  illustrates the extent of the Irish regulator’s incompetence and/or criminality, and refusal to actually enforce regulations.

You can find more on Ireland’s regulatory cess pit and WhistleblowerIRL’s story in  Why Bank Regulation is a Joke, and Who Bankrupted Ireland.  For more the details of WhistleblowerIRL’s very much ongoing story see his blog here.

Of course if you want no regulation why not just go to the Caribbean?  The answer comes back to the German banks again.

Much of the money flowing into Europe looking to be invested would end up in Special Purpose Entities/Vehicles (SPE, SPV) or Structured Investment Vehicles (SIVs). These are the legal containers which house and run the securities in a Collateralized Debt Obligation.  You securitize debts, you  put them in a CDO you  house the CDO in an SPE/V or SIV and you need somewhere to set up and domicile the SPE/SIV.  What Germany wanted was to have the dubious advantages of off shore combined with the above board respectability of Europe. German investors, the Landesbanks, wanted their money inside the OECD cordon of respectability while getting all the perks of off-shore. Ireland provided both.

A former, very senior banker from Depfa told me the Landesbanks could not buy Depfa’s debt/Asset Backed Securities fast enough.  Any issue Depfa made would be pre-sold to and wolfed down by the landesbanks before the ink was dry.  This was a partnership.

Now before I wrap this first part up, I would just like to note that,

Another banker, based in Germany, has recently pointed out to me that in all of the discussion about the Greek-Ireland-Spain/Portugal bailouts, the debate over the tax-payers’ money that was, and still is, being poured into the now-nationalised HRE/Depfa has mysteriously been silenced. I wonder why? The banker referred me to this documentary which raises some interesting questions about why and how HRE was bailed-out. It makes the importatnt link to Akerman at Deutsche Bank and how he appears to have told, not advised, but told, Merkel what to do. Merkel might be more of a tin wind-up model of an Iron lady rather than the real thing.

As I have very basic German-language skills, I would welcome any comments readers might have about these documentaries. This would help me to learn more about the HRE/Depfa saga.

On that note I am going to break the story here to stop this becoming too large.  I will continue in the next part with the question:

So what went wrong?  And why did HRE buy Depfa when it was already going wrong?


In which we will meet once again our old adversaries AIG and Goldman Sachs.