What is Counterparty Risk?
In its most general sense, counterparty risk reflects the odds that a party to an agreement will fail to live up to their end of the bargain, leaving those at the other end of the deal holding the bag. ETF investors are exposed to varying degrees of counterparty risk from a number of different sources. It is important for investors to understand the sources of counterparty risk in ETFs and the ways that ETF providers seek to minimise it.
What Are the Sources of Counterparty Risk in ETFs?
There are multiple sources of counterparty risk in ETFs which vary depending upon the fund's structure. Physical replication ETFs tend to carry the lowest degree of counterparty risk. The chief source of counterparty risk in physical replication funds is securities lending. ETF providers running physical replication funds will often lend positions in their portfolio constituents to short sellers hoping to profit from a fall in the price of the security in question. As borrowers pay interest on these loans, this practice generates income for the ETF provider, a portion of which can be shared with fund holders in the form of lower expenses. However, this also leaves the provider exposed to the risk that the borrower will fail to return the securities.
Swap-based ETFs are exposed to a higher degree of counterparty risk relative to physical replication funds. Swap-based funds mimic the return of their benchmark by entering a total return swap. Under the terms of the swap, the fund's counterparty is obligated to deliver the return of the fund's reference index in exchange for the performance of a basket of securities held as collateral, which the fund delivers to the counterparty. This arrangement exposes shareholders to the risk that the swap counterparty will fail to deliver the benchmark return.
Exchange traded notes are exposed to the highest degree of counterparty risk of all of the ETF structures currently in existence. ETNs are essentially an unsecured debt instrument. If an ETN's backer were to go under, ETN holders would have to stand in line with the issuer's other unsecured creditors--and behind secured debt holders--hoping to be made whole. At present, the ETN structure has seen very limited adoption in Europe.
How Can It Be Minimised?
ETF providers actively manage counterparty risk in a number of different ways. Purveyors of physical funds keep close tabs on the borrowers to which they lend securities, making sure that they score high marks on the creditworthiness scale. Synthetic funds are often fully, if not over-collateralised. A ring-fenced basket of readily marketable collateral securities held in the name of the ETF's shareholders protects investors in synthetic funds against a potential default by the fund's swap counterparty. These collateral baskets are regularly marked-to-market, and any shortfall in required levels of collateralisation is immediately remedied by the counterparty by posting additional collateral. Finally, ETN holders are largely on their own when it comes to protecting themselves from counterparty risk. Again, ETNs are basically unsecured debt obligations (they have no collateral backing), and in the event of a default by the issuer, investors may be left out in the cold. Purchasing a credit default swap on the issuer's debt (essentially a form of insurance that would pay off in the event of an issuer's default) could help to mitigate the counterparty risk associated with an ETN investment. However, a simpler solution would be to simply search for an ETF that provides similar investment exposure with a lesser degree of counterparty risk.
