Surprisingly little note has been paid to the discussion of ETFs in three reports issued last week by international regulatory heavyweights, namely, the IMF, the BIS, and the G20 Financial Stability Board.
Make no mistake: the authorities are worried. The BIS report, for instance, has an unflattering comparison on its first page, noting that now ETFs seem to be serving the same function for institutional investors now as structured credit products did in 2002-2003, with dealers pushing the envelope as far as “innovation” is concerned. The Financial Stability Board was more straightforward, flagging its concerns that ETFs could pose a threat to stability in its report title.
The regulators discussed the fact that “ETF” no longer stands for a single product. Most investors probably assume that an ETF is more or less a mutual fund, when in fact Eurobank affiliated groups’ products are typically synthetic (that is, they use derivatives rather than securities. There are even more structural variants, but we’ll stick to these two for the purpose of this post). And too often, the relationship between the ETF and the sponsor is not arm’s length.
Paul Amery at Index Universe provides an overview:
The focus in the BIS paper on regulatory arbitrage by banks—the use of ETFs as a funding mechanism for parent investment banks, with the maturity of the swap being used to disguise the fact that the bank is effectively receiving overnight funding from the ETF while also obtaining relief from key liquidity metrics for the calculation of bank capital requirements—raises serious questions about the whole business model of synthetic ETF replication.
Mind you, this does not mean that the “physical” ETFs are paragons of virtue either. They merely play close to the wind in another manner, through securities lending (remember how that blew a $20 billion hole in AIG’s balance sheet?). Amery again:
According to the FSB paper’s authors: “Securities lending…may create similar counterparty and collateral risks to [those incurred by] synthetic ETFs. In addition, securities lending could make the liquidity position of the ETF fragile, by challenging the ability of ETF providers to meet unexpected liquidity demands from investors, particularly if outflows from ETFs become significant under severe stress. A prevalence of securities lending could create a risk of a market squeeze in the underlying securities if ETF providers recalled on-loan securities on a large scale in order to meet redemptions. In addition, 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.
Note that the US has pretty strict limits on rehypothecation, and recall that the lack of similar rules in the UK was a big (we’ve also warned about doomsday machine-type rehypothecation schemes). In case this concept is new to you, an overview from a 2010 post:
Despite its daunting name, rehypothecating is not that hard to grasp. Imagine you operate a pawn shop. People bring things that are valuable and leave them with you as collateral for loans. In rehypothection, you as the pawn broker have gotten permission from the people who have provided their assets to you to take them to another pawn broker and get a loan from them.
You can already see this sounds dodgy. How many times might your gold watch be passed from pawnbroker to pawnbroker? And if the pawnbrokers were each willing to lend a high percentage of its market price, the loans made against this one watch could easily exceed its value.
The irony is that the US recognized the potential for abuse with rehypothecation long ago and provided for strict limits during the Depression. The Securities Exchange Act of 1934 limited the level of rehypothecation to 140% of customer loan balances. The rest of the assets must remain in a segregated account. By contrast, as Singh and Aiten remind us, there are no restrictions on rehypothecation in the UK and no customer protection laws (the US also has SIPC to provide some restitution in the event of a broker-dealer failure). The lack of restriction in the UK allowed hedge funds and dealer prop trading desks to achieve higher levels of leverage, but left many funds badly exposed when Lehman’s London operation, which had rehypothecated customer assets, collapsed. Needless to say, that mess has made participants a good bit more careful, with the result that the paper estimates that the total amount of assets that were permitted to be pledged fell from $4.5 trillion at the end of 2007 to $2.1 trillion at the end of 2009.
Note that rehypothecation is a source of funding to dealers (remember, if your pawnbroker can get a loan against your watch, he can use it to fund his business).
And that’s why both these practices bears some scrutiny. As the IMF warns:
Bankruptcy laws surrounding counterparty defaults and the potential freezing up of collateral at custodial banks remain areas of concern for ETFs involved in TRS [total return swap] and securities lending. In a variation of the swap-based ETF, the provider sometimes transfers all the cash from investors to the TRS counterparty, which in turn pledges collateral to the ETF’s account at the fund’s custodian bank.73 In such a scenario, if the swap counterparty were to default, it could potentially lead the bankruptcy administrator to freeze all ETF assets, preventing the ETF from liquidating its assets if the need arises. Also, the TRS counterparty has an incentive to provide lower-quality collateral in such an exchange, leaving the ETF provider with potentially illiquid assets to offload in the case of a default of the counterparty.
The good news is that Amery highlighted various ETF sponsors putting out press releases, some of which were pretty disingenuous. It appears that these reports are laying the groundwork for clearer disclosure and tightening of some rules. But how quickly that happens and whether it gets the Eurobank affiliated funds out of the dodgy business of providing cash to their sponsors remains to be seen.
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Okay, I’m willing to admit that I’m confused here.
Are the ETFs now using derivatives of exchange trades…?
So… if one were going to do an ETF of food commodities, could one then make a derivative of an aggregate of corn + wheat supplies, then turn that into a derivative (via the math mumboJumbo), then sell it repeatedly — per the story of the gold watch – in order for Peter to buy from Paul to sell to Mary… by which time, the price of the commodities is now far lower than what it could possibly be sold for the next go-around…?
Somehow, I have in my mind’s eye a silo of wheat and corn, divided into 1,000,000 bits, each of which — a la derivative math — has its own individual differential equation. Each of those 1,000,000 bits can then be sold, traded, far in excess of their real, underlying value.
So we end up having 100 people, each of whom believe they have paid $1,000 for their 1/1,000,000,000th of the corn silo. When in fact, their 1/1,000,000,000th is in fact only worth about $455.
And of those many trades, over half of them passed through tax havens, and the trades of many of those transactions were never recorded for tax purposes.
So as far as government revenues from all that trading, perhaps the governments collected $5 for all that flurry and exchange.
I must surely be very confused about all of this, and what it means.
Dear heavens, I surely hope that I am!
Most ETFs aren’t on commodities but are on equity indexes or sub-indexes, sometimes levered, sometimes inverse. GLD actually hold real gold. There are also currency ETFs. So think in terms of stock indexes as the base case.
Ah.
Apologies to Yves and other readers, but for the life of me the way this appears is that the more these items are traded, the less underlying value they retain.
Either I am completely understanding this.
Or else, I am like the kid who in that old story kept insisting that the Emperor was not wearing elegant designer clothing, he was stark, buck naked. (It had never occurred to me prior to this thread that The Emperor’s name was Mr “Naked” Capitalism, but I’m a bit slow on the uptake… sigh.)
Apologies to Yves and other readers, but for the life of me the way this appears is that the more these items are traded, the less underlying value they retain
There is an effective truth in what you say with some of the ETF’s. Some (all?) levered inverse ETF’s use CDS’s as the actual hedging vehicle and there is a small arb cost that erodes the value of the ETF.
“So we end up having 100 people, each of whom believe they have paid $1,000 for their 1/1,000,000,000th of the corn silo. When in fact, their 1/1,000,000,000th is in fact only worth about $455.”
More worryingly, don’t you end up with a 100 potential bakers who believe they have paid $1,000 for enough wheat to bake a thousand loaves when in fact they would only actually be given enough for 455 loaves?
And Governments who have done all their sums on the basis that they have 100 bakers promising to deliver 1,000 loaves each to the population?
Correct-a-mondo, except its more like stored electron arb…see black box for physical…snicker.
Skippy…market mosaic multipliers…lol.
Thanks for clarifying comments. And this:
seems all too familiar.
Clearly, the population will have to undergo Bread Austerity.
The government, presumably, being helpless.
ETFs are nothing more than a species of derivative traded in the secondary equity markets. If you actually bother to read how they’re structured, often as some form of swap agreement, you’ll see what I mean. That’s why I’ve stopped putting any money in them.
There are some ETFs that appear a lot more legit (e.g., SGOL), but I don’t trust even those (i.e., I believe JPM is the bank that holds SGOL’s gold).
I had some ETF exposures during the crisis (I’m capital R retail, worse in retirement funds, which means I can’t do futures or options but can do ETFs) and got freaked out about the ETF I was using to short the S&P. My buddies rang around and determined its swaps were well diversified with really solid counterparties. But who wants to have to worry about stuff like that? And even if you think you are getting good intelligence, how certain can you be?
Don’t understand why you can’t do futures? Surely with someone like InteractiveBrokers you could do most ET derivatives (possibly not write naked options, but who would want to do that anyways.. )
You can’t do futures in a retirement account. Under the law you can but no IRA custodian will permit you to do it.
When I last looked into it, ~ 10 years ago, there were only two IRA custodians who’d permit you to use futures. They were the favorite of Chicago traders who often had millions in IRAs (rolled over from pensions).
One was an Illinois bank. I forget their name even though I had an account with them. They were famous for world class awful service. A trader had literally come to their office and smashed their computers out of frustration. The bank sued him and their conduct had been so demonstrably bad that the judge awarded them only the broken computers.
I similarly got in a row with them (not the computer smashing kind) and they actually threw me out as a customer. Turns out that was a big favor. They were closed down six weeks later for embezzling customer accounts. And guess what, embezzlement is not covered by FDIC insurance.
The other firm that was willing to handle IRAs for futures trading was Refco. Also shuttered for embezzlement of client assets.
I’ve noticed quite a while ago that DB was pretty big about swaps. Good that Yves is pointing these things out. A bit late maybe, but I guess they were less big three years ago.
Confirms that the casino is at work as a lot of the things described are just ways of betting, perhaps we need to change the name of the SEC to the Securities Exchange and Gaming commission.
We can choose to not gamble at a casino and it doesn’t have much effect on our personal finances. But when these crooks & criminals choose to gamble like this it puts us all at risk. Nor is there anything ‘we the people’ can do about it, not a single solitary thing. Something has to change & soon…
EFT = Ethereal Transaction Fraud
Any time you have transactional orders of magnitude above the physical supply, there is a disconnect with reality, a potential for unmitigated fraud.
Skippy…GLD ETFs ROFLMAO[!] a promise by whom?
Can you throw more light on how GLD and other Gold ETF’s function? Aren’t they obligated to buy real gold based on how much was purchased or sold? I can understand a 10% buffer or else this is another speculating tool. Thanks.
http://ftalphaville.ft.com/search?q=Izabella+Kaminska+etf
She has done some great reporting on ETF’s from London.
The “market makers” or authorized participants, are apparently under no demand to keep a bid under them, they are just “authorized” to arb the spread between the ETF and whatever it is tracking.
A valuable post.
“Most investors probably assume that an ETF is more or less a mutual fund”
Sure. ETFs are – in many ways – a part of the global Ponzi. And the Ponzi is not only on the banking side. The so-called “investor” is quite often not one. A significant percentage of these investors (sic) are highly leverage bet makers as well.
An investor is investing their own saved money. Not Bernanke-pumped liquidity.
Risk is on both sides.
“Open interest in gold futures and options traded on the Comex typically exceeds supplies held in its warehouses. If the holders of just 5 percent of those contracts opted to take delivery of the metal, there wouldn’t be enough to cover the demand, Bass said.”
http://jessescrossroadscafe.blogspot.com/2011/04/standard-and-poors-changes-us-debt.html
Not such a surprise perhaps. But it certainly was an eye opener when it was put forward that the LBMA, the London Exchange where bullion is held and traded, as security at times for other futures exchanges, is dealing at leverages of 100 to 1.
House of cards, perhaps. Even those who think they may hold ‘bullion’ many not actually own it, as it is routinely lent out and resold in the manner of the pawn shop example, if it is in an unallocated account, or perhaps even if it is represented as having a clearly allocated title.
Digitization of physical commodity’s too me is like a dry Martini, wave the Vermouth cap over it and pronounce it a blended cocktail. Yet you pay for the full jigger of Vermouth…sigh…extra olives saltiness do disguise the the lack there of…lol.
Skippy…Jesse, it’s amazing the lengths they have gone too. On one hand its the anathema to zero reserve fiat and on the other they give it the same dilution treatment, but, store with great care…me wonders why. As we live in a ownership society_me thinks_paper is a poor choice, 9/10s thingy…eh.
PS. thanks for staying on top of every thing via blog.
All forms of securitization (and credit derivatives) are simply ways of the banksters creating and extending debt peonage.
Which is why Prof. George Jackson, Dmitris Chorafas, Chris Whalen and John Kenneth Galbrain, when he was alive, all kknow or knew that securitization originally began in America back in 1909, then really took off in the Roaring 1920s, but was ended in American around 1933 as the realized it was part of their Ponzi-Tontine scam on America.
Any jackhole today who claims securitization begain in the ’70s or ’80s can’t locate their own genitalia.
End of story. And ETFs fall into those securitized financial instruments category.
“The focus in the BIS paper on regulatory arbitrage by banks—the use of ETFs as a funding mechanism for parent investment banks, with the maturity of the swap being used to disguise the fact that the bank is effectively receiving overnight funding from the ETF while also obtaining relief from key liquidity metrics for the calculation of bank capital requirements”
Can someone please explain how this works? Thanks in advance.