Trading was suspended in London this week for some vehicles issued by ETF Securities, because the funds relied on counterparty arrangements with AIG (Reuters). The dirty little open secret of levered and short ETFs, and many others, is that they rely on swaps to get that near-perfect tracking of their underlying indexes.
“LONDON, Sept 16 (Reuters) – Some banks and brokerages ceased making markets in commodity securities backed by matching contracts from troubled insurer American International Group Inc … on Monday afternoon, ETF Securities said on Tuesday.
The affected securities are known as exchange traded commodities (ETCs).
ETF Securities said on its website it was “actively working on possible ways of providing investors with liquidity” — including arranging suitable collateral for market-makers.
As of this evening, ETF Securities was reporting that it was an apparent beneficiary of AIG’s nationalization:
AIG confirmed that last night there was an announcement by the Federal Reserve Board, that the Federal Reserve Bank of New York is providing a two-year, $85 billion secured revolving credit facility to AIG that will ensure the company can meet its liquidity needs.
AIG has continued to honour all of its obligations under our agreements with them, including processing all creations and redemptions in the usual manner and paying all redemptions due on time.
Like money market funds breaking the buck, this is one more risk that few investors have ever thought possible. Popular issuer ProShares spells it out in their prospectus (my underlining):
Swap Agreements Swap agreements are two-party contracts entered into primarily by institutional investors for a specified period ranging from a day to more than one year. In a standard “swap” transaction, two parties agree to exchange the returns (or differentials in rates of return) earned or realized on particular predetermined investments or instruments. The gross returns to be exchanged or “swapped” between the parties are calculated with respect to a “notional amount,” e.g., the return on or increase in value of a particular dollar amount invested in a “basket” of securities representing a particular index. The Funds are subject to credit or performance risk on the amount each Fund expects to receive from swap agreement counterparties. A swap counterparty default on its payment obligation to a Fund may cause the value of the Fund to decrease.
Now, swaps are not the only assets of these ETFs, so they may not go to zero in a counterparty default, but we don’t know exactly what fraction of a given fund is at risk. Nor do we know who the counterparties are in all of the ETFs. ProShares keeps their counterparties a secret, though they did assure us this week that Lehman and AIG were not among them.
Back to analog
Seeing as all major investment banks are on the ropes, it may be time to think about other ways to go short, such as old-fashioned short selling or buying puts. I’m a fan of LEAPS puts for a number of reasons, including the greater default protections of the options market.
It is worth mentioning that there are some work-arounds possible with levered ETFs that mitigate counterparty risk: shorting a levered long ETF or buying puts on a short ETF that you are long. Or you could allocate a small amount of capital to calls on a levered short ETF to limit your losses in case of default.
Why not more disclosure?
If ProShares or other issuers are implementing measures to eliminate counterparty risk, they should be forthright about it, otherwise we have to fear the worst. Is there more than one swap counterparty per fund? Just how much of each fund relies on uncollateralized swaps? How often is collateral rebalanced? If it is done daily, I would be OK with that. No biggie to lose out on one day’s gains, even a big day — I just don’t want to lose the whole wad.
We are entering uncharted waters here, and trust is in short supply for good reason.