Concerns about the risks of swaps-based exchange-traded funds may be encouraging ETF issuers to use futures contracts to manage their products, particularly given the greater focus on counterparty risk and delta-one trading following the emergence of UBS's $2.3 billion trading loss.
Fund houses are preparing ETFs based on the new S&P CNX Nifty Futures Index, says Michael Syn Hsien-Min, head of derivatives at Singapore Exchange, but he would not reveal any company names.
S&P Indices launched the S&P CNX Nifty Futures Index on June 27 to track the National Stock Exchange of India's headline Nifty stock index. SGX accounted for 52% of the global market share in Nifty futures by open interest as of September 1.
Industry observers say they also expect to see products providing similar access to other markets, such as via SGX FTSE China A50 futures.
There are already privately arranged structures providing long and short exposure to both China and India using SGX futures, says Syn, but growing interest in ETFs has led the exchange to licence more than 40 variations of excess-return/total-return India indices to S&P. These benchmarks include volatility-targeted and multi-currency products.
SGX also works with issuers who wish to use private-label versions of Asian equity indices, says Syn, and several ETF providers already follow this approach. Indeed, BlackRock – the world's biggest ETF issuer – is reportedly considering doing so.
The exchange is also working on dynamically hedged strategies to offer volatility control and principal protection using SGX futures, for which it has had enquiries from structurers and issuers of exchange-traded funds and notes.
“We are looking into some initiatives that will allow people to benefit from a well-thought-through solution to exchange trading and clearing of volatility as a portfolio asset class,” says Syn, who declined to give specific details.
Centrally cleared futures represent a solution to the issues around ETFs of swap counterparty risk and P-note counterparty/liquidity risk, argues Syn. Market participants – such as Wyllie Tollette, Franklin Templeton’s risk-management head – have highlighted concerns such as the potential concentration risk and tracking error of ETFs, particularly for less liquid markets like frontier economies.
“Synthetic replication offers the benefits of a formulaic replication, but some regulators are concerned about collateral, unwinding, diversification and counterparty risk on one side,” explains Syn.
And the focus on counterparty risk and 'access products' further intensified with a late-August move by Hong Kong's Securities and Futures Commission to tighten up on collateral posted against exposure.
ETF managers must ensure that by October 31 all their Hong Kong-listed synthetic ETFs are fully collateralised. Moreover, synthetic ETF managers must also put in place a “prudent haircut policy”, in that the market value of collateral taken in the form of stocks must be equivalent to at least 120% of the related gross counterparty risk exposure.
“However, this doesn't change the underlying fact that access through futures is potentially more liquid and suitable,” says Syn.
Using SGX China A50 futures as an example, he says the contracts have a notional size of less than $10,000, meaning intra-day hedging can be very fine-grained and accurate. The cost of executing an A50 futures contract is also substantially more timely and efficient than buying 50 individual A-shares, especially in small size.
Moreover, he notes, the A50 futures market remains open after the A-share market shuts, which is useful for those wanting to provide a global product rather than a regional one.
In addition, the collateral posted to the clearing house is a fraction of the notional exposure, says Syn, so there is always significant free cash balance for the ETF manager to cope with redemption considerations.
However, many issuers that use swaps are likely to continue doing so rather than switch to futures to provide exposure, argues Christine Huang, vice-president of sales and marketing at Lyxor ETF in Hong Kong.
Swaps tend to track the index more closely and are cheaper than futures, she says, adding that the counterparty risk is manageable, being limited to 10% of the exposure under the Ucits rules.
But market-makers and liquidity providers will continue to use futures for hedging their trading positions, adds Huang.