Evaluating Counterparty Risk

When and where does your investment depend upon the promises of others?

In any portfolio, it’s crucial to understand the source and extent of all types of risk—counterparty risk is no exception. So, when and where do exchange-traded products (ETPs) host counterparty risk? How can we identify and assess this risk?

When investing in an ETP, investors are dependent upon the ETP issuer, among others, to deliver on their side of the transaction. After all, ETP issuers deduct management fees on a daily basis, and ETP investors rightfully expect their investments to be safe and to deliver the pattern of returns promised by the product’s prospectus.

In evaluating ETP counterparty risk, the first distinction to make is the type of ETP (exchange -traded fund (ETF), exchange-traded note (ETN), exchange-traded commodity (ETC))) and whether it’s physically or synthetically backed.

In general, physically backed ETFs bear less counterparty risk than their synthetically backed cousins: If the issuer of a physically backed ETF fails, the investor has direct recourse to the ETF’s underlying shares—leaving investors with minimal, if any, counterparty exposure. The fund is the entity that owns the securities, and you own the fund. The issuer is, essentially, your employee.

However, some physically backed ETPs incidentally add counterparty risk to their portfolio in an attempt to generate additional returns for investors. They do this by lending their portfolio securities to borrowers who pay a fee and deposit collateral to do so. Even with collateral, lending securities to a borrower and reinvesting their collateral introduces counterparty risk to the portfolio—however minimal.

In contrast to physically backed ETPs, synthetically backed ETPs depend upon derivative contracts to gain exposure. These derivative contracts are often written by third parties like major money center banks.

Whereas investors in physically replicated ETFs own a direct claim on assets, investors in synthetically backed ETFs own a claim on a promise. The promise, of course, is for the swap underwriter to pay the returns of an index. That promise, however, is only as good as the underwriter’s ability to pay.

How risky is that promise?

First of all, the counterparties to the swap contracts that back synthetically replicated ETFs are deep-pocketed financial institutions with strong credit ratings. Immediately, that takes some of the risk off the table. Understandably, with the failure of big banks in recent memory, “strong credit ratings” is not the most assuring guarantee.

To remove risk further, Undertakings for Collective Investment in Transferable Securities (UCITS)-compliant ETFs cap counterparty exposure at 10% of the fund’s net asset value, so even if the counterparty defaults, the ETP would only be out a maximum of 10%.

Even then, many ETPs reduce counterparty exposure and risk further by exchanging collateral with counterparties and/or settling outstanding balances regularly. Check the prospectus for details on each ETP’s policy regarding collateral and swap settlement.

Unfortunately, swap counterparty information is only disclosed on an infrequent and lagged basis, so quantifying counterparty risk via tools like credit default swap rates is difficult and imperfect.

It’s also worth noting that the two types of swap-based ETFs—unfunded and fully funded—bear different degrees of counterparty risk: Fully funded swaps are over-collaterised, so their investors have lower counterparty risk than the equivalent unfunded swap-based ETF. That said, many unfunded swap-based ETFs have come a long way in reducing counterparty risk and collateralization levels.

Beyond the swaps-based ETFs, ETN and ETC investors have the biggest counterparty risks. Since an ETN is just a debt instrument like a bond, the entire value of an ETN is dependent on a single counterparty’s ability to make good on its promises. In the case of ETNs, that single counterparty is the issuer. ETCs are largely the same, as investors are exposed to a single counterparty. The only difference is that the counterparty is usually a third party to the issuer.

Ultimately, even with all the advantages that ETPs offer, they’re not without some structural risks. Those interested in minimizing counterparty risk above all else may prefer physically replicating ETFs to ETNs and, if a swap-based ETP is necessary, fully funded products to unfunded products.