The Sweet, Short LifeOf Synthetic ETFs

You've heard of structured products. These largely were complex securities based on lots of streams of cash in underlying loans whose flows were not well predicted. There was a credit crisis associated with them in 2008. 
Now come "synthetic" exchange-traded funds, where interest-rate swaps and other derivative products are used to replicate the performance of a securities index. 
Only synthetic ETFs are likely to disappear almost as fast as they arrived. The European Securities and Markets Authority this year is expected to introduce new rules that get tougher on the collateral required for synthetic ETFs. That will, according to researcher Celent, make them "costlier and less attractive to asset managers and investors alike." 
That may not matter much in the United States. While this country is by far the largest market for exchange-traded funds, investment pools here are more interested in so-called "physical" ETFs. In such funds, there is investment in actual physical products such as stocks, bonds or commodities. 
Synthetic ETFS have not made much of a dent here, amounting to about 3% of the market in the United States. They have not fared much better in Asia, where they account for 11% of assets placed in ETFs. 
But in Europe, they've been hugely popular. By Celent's calculations, their share of the overall European ETF market rose from around 21% in 2005 to more than 45% of the value of funds in 2011. 
The asset managers that run synthetic ETFs are often affiliated with leading banks, says Celent Senior Analyst Anshuman Jaswal. 
Being part of the same group offers them access to securities that would otherwise sit idle with their affiliated bank. These securities are used as collateral by the ETF managers, which helps them to save on collateral management costs. That makes the synthetic ETFs cheaper than their physical-products-based brethren. 
Thus, says Jaswal, "the synthetic ETFs are cheaper." 
The overall volume of trading in synthetic ETFs has declined since 2007-the year before the subprime mortgage market imploded and the market in securities based on the cash flows from mortgages went with it. 
But Europe has remained at the forefront of producing synthetic ETFs. Of all issuance in the world, Europe accounted for 87% in 2010. The U.S. share? 6%. The rest of the world? 7%. 
The European love of synthetic ETFs appears to be ending, however. 
European-listed exchange-traded funds and products had net new inflows of $28.1 billion in the first 10 months of 2010, according to Celent. 
But a greater regulatory scrutiny of synthetic exchange-traded products has led to declines in their volume of issuance and trading. 
Last year, physical exchange-traded products attracted the majority of inflows in Europe, at $26.8 billion, by Celent's count. That was about a billion dollars more than went into physical ETFs, on that continent. 
Meanwhile, synthetic ETPs pulled in $1.25 billion in new flows.  
"This was a big change from 2010 when synthetic instruments managed to attract more inflows than physical ETFs,'' Jaswal said, in a report prepared for Celent and published at the turn of the year.  
Regulations in the United States are stricter, he says. Europe's rules, under its Undertakings for Collective Investment in Transferable Securities initiative are more flexible. 
In the United States, ETFs must hold at least 80% of their assets in securities matching the fund's name, and 85% of the assets must be convertible to cash in seven days time. 
In Europe, assets in the collateral basket are eligible for securities lending, and secured lending is usually done through a custodian. The extent of the cost savings can be influenced by the applicable haircuts for the collateral assets under UCITS, and rules on haircuts vary across jurisdictions.  
As a result, synthetic ETFs exhibit characteristics of so-called structured products. Investors don't necessarily know who their counterparties are. There can be a buildup of systemic risk, as Celent notes. 
The derivative transactions between ETFs and affiliated banks "result in the build-up of counterparty credit exposures between market participants,'' it says. 
When derivatives such as swaps are used to replicate the return provided by a particular index, investors often do not know the extent of their exposure to the derivatives and their counterparties are also often unknown. 
That can pose "liquidity risk" to banks acting as swap counterparties "if there is a sudden withdrawal of investors from the ETF market,'' Celent contends. 
In addition, disclosure can be deficient on the nature of the derivatives transactions involved and the the quality of collateral received from counterparties. 
"There is a tendency to progressively shift collateral pools over time to include illiquid assets. If there is little overlap between assets in the collateral basket and the index basket, this might cause institutional investors to liquidate ETFs that are replicated synthetically in a time of growing counterparty risk,'' Jaswal writes in his report. "Large withdrawals from ETFs could raise correlation across asset classes sharply and cause volatility in the global capital markets.'' 
By using a variety of markets and players to replicate their benchmark indices, ETFs make it difficult to make a risk assessment of the end product sold to investors, he contends. Transparency is reduced as a result, and there is little investor monitoring of the index replication process when this function is taken over by the swap counterparty.  
But that is expected to change, this year. "We believe that the guidelines that are expected to be issued by the European Securities and Markets Authority in 2012 will be strict with an emphasis on controlling counterparty and associated systemic risk,'' his report assets. 
As a result, the volumes managed in the synthetic ETF industry in Europe are expected to decline. Which means even less than $1.25 billion could go into synthetic ETFs in 2012. 
This will bring the European industry in line with the United States, with only two or three% of assets under management in exchange-traded funds going into the synthetic varieties. 
Here, the assets placed in synthetic products is "quite low due to regulatory restrictions,'' by Celent's assessment. 
The introduction of the new rules by ESMA will "be crucial for the further growth or stagnation of the synthetic ETF industry in Europe,'' says Jaswal.