04 May 2012

ETFs Part 2: The Next MF Global or Trigger For a Broader Collapse - But Timing Is Everything

It is the introduction of synthetic derivatives in place of actual holdings, and the abuse of counterparty exposure with one's own organization thereby concentrating risk, that start to make these financial creatures look even more deadly, and more like control frauds, than one might have previously imagined.

I think that when one of these constructions fails, as one must almost surely do, we will then have either an MF Global moment, wherein one institution goes down and quite a few customers find that they are holding worthless paper instead of assets, or even worse, an enmeshed counterparty risk triggers another Lehman-like freeze in the credit markets and, as the dominos fall, a new financial crisis even worse than the last.

The nastier version would almost certainly occur if the failure and subsequent disclosure of fraud occurs in some commodity ETF. Why?

In that instance it is more difficult and much more noticeable, although not impossible, for the Congress and the Fed to throw loads public money, and subvert justice, to make the problem and full disclosure of fraud to go away.

Stocks and bonds are relatively easy to counterfeit; physical commodities take a little more energy, boldness, and imagination, the challenge of the shell game rather than the relatively mechanical process of inflating the world's reserve currency on behalf of financial friends with benefits.

So before you short stocks in your trading account, with abandon and quite possibly into insolvency, keep in mind that the Fed is perfectly capable of fomenting another bubble to save the status quo, as they did in 2002-2007. To underestimate the corruptibility of the Fed and the government in partnership with the banks and their corporations can be a costly lesson indeed.

ETFs – Part 2

So far so vanilla. Now lets look at how, as the ETF market has grown, the clever boys and girls of finance have found ‘innovative’ ways of pumping those ETFs up a bit, just like they did to Securities.
Use of Derivatives in ‘Synthetic’ ETFs

The main innovation in ETFs has been the creation of what are called ‘synthetic’ ETFs which instead of actually buying or even borrowing a basket of shares, use derivatives to track the value of the underlying market without the need to match its composition. Instead the Synthetic ETF enters into an asset swap agreement with a counterparty using an over-the-counter (OTC) Derivative. Before explaining what the heck that means let’s just look at how quickly the Synthetic market has grown.
Synthetic ETFs have grown very rapidly in Europe and in Asia. In Europe Synthetic ETFs are now 45% of the over all ETF market. Synthetics doubled their market share between 08 and 09.

The key to Synthetics is the Counterparty.

What happens is the ETF Sponsor designs the deal, the AP (Apporved Participant. Usually one of the big banks or brokers) buys the basket of assets to make it, but then swaps that basket with the Counterparty for a different basket of assets in a derivative swap deal. However it turns out that rather too often for comfort, not only will the Sponsor and the AP be the same bank, but more often than not it will be the Asset Management branch of the same bank who will be the Swap Counter-party as well. It is quite common for the same bank to play all three roles. So a single bank creates the ETF, appoints itself as AP so it can fund it and then its Asset Management desk becomes the derivative counterparty in order to mutate the whole thing into a synthetic ETF. Think about what this does to the risk. What was market risk, where the risk was spread out across all the different shares, is now a single counterparty risk. The bank has effectively put all the ETF’s risk in one basket – itself.

But even if it is a different bank acting as the derivative counterparty the situation is only very slightly less incestuous because it is nearly always the case that the Sponsor, AP and Counter-party will all be from the same small group of big banks, brokers and Asset Managers. And it is also a statistical fact that all of them will be counterparties with each other many, many times over, via the over $1.2 Quadrillion of other repo, rehypothecation and derivative deals. This, as the Financial Stability Board’s report on instabilities in the ETF market rather laconically puts it,

…may also generate new types of risks, linked to the complexity and relative opacity of the newest breed of ETFs. The impact of such innovations on market liquidity and on financial institutions servicing the management of the fund is not yet fully understood by market participants, especially during episodes of acute market stress.
Not fully understood? I think we may not have understood what such entanglements of reciprocal risk meant before the first period of ‘acute market stress’, but I think now it is nutty to imagine the banks don’t know how risky such risk incest really is. The FSB report itself concludes,
Since the swap counterparty is typically the bank also acting as ETF provider, investors may be exposed if the bank defaults. Therefore, problems at those banks that are most active in swap-based ETFs may constitute a powerful source of contagion and systemic risk.(P.4)
Please step forward Deutsche Bank and Soc Gen!

A “powerful source of contagion and systemic risk”. Sounds really good for you and me. So why are the banks doing it anyway? The official answer is that using Derivatives means the ETF can track the value of the market more closely. Though few have complained that Vanilla ETFs don’t track closely enough. And as the BIS report points out,
…the lower tracking error risk comes at the cost of increased counterparty risk to the swap provider. (P.8)
But this doesn’t answer why a bank would enter into a swap with itself as the counterparty. The whole idea of counterparties, once upon a time, was to hedge some of the risk in the original deal by passing it off to someone else. Using yourself as counterparty keeps the risk in-house. So once again why?
The answer is, according to the BIS report on ETFs,
…that this structure exploits synergies between banks’ collateral management practices and the funding of their warehoused securities. (P.5)
‘Synergies’ sounds like it should be good. Sadly it may not be. As the BIS goes on to explain,
…synergies arise from the market-making activities of investment banking, which usually require maintaining a large inventory of stocks and bonds …. When these stocks and bonds are less liquid, they will have to be funded either in the unsecured markets or in repo markets with deep haircuts. (P.8)
In essence it costs the banks money to have illiquid assets on their books. The repo markets won’t accept them as collateral unless they come with a deep haircut. So the banks can do little with them except sit on them. Basically it costs the bank to have the illiquid, hard to sell or Repo, stocks on its books. But.. .if they happen to have created a handy synthetic ETF, then everything changes because,
For example, there could be incentives to post illiquid securities as collateral assets [in the ETF Swap]…. By posting them as collateral assets to the ETF sponsor in a swap transaction, the investment bank division can effectively fund these assets at zero cost….
Handy isn’t it? Assets they can’t repo without hefty haircuts can be posted as collateral to their own ETF with the approval of the ETF Sponsor of course – who will just happen to be… the same bank – without those pesky, hurtful haircuts. In fact,
The cost savings accruing to the investment banking activities can be directly linked to the quality of the collateral assets transferred to the ETF sponsor.
The worse they are, the more illiquid, the more the bank saves/makes by choosing to put them in an ETF rather than having them loiter on its books.
…the synthetic ETF creation process may be driven by the possibility for the bank to raise funding against an illiquid portfolio that cannot otherwise be financed in the repo market. (FSB report P.4)
This is surely financial innovation at its shining best.

Now of course the banks will say they would never consider slipping some old tat into their ETF under cover of opacity. Except that they did, every one of them, do exactly that when they systematically and grossly lied about every single aspect of hundreds of billions worth of shabby mortgages which they intentionally stuffed into CDOs in order to shaft and rob those they sold them to. This is a matter of public record...."

Read the rest here.

See also Part 1 - ETFs and Derivatives Will Be the Trigger Event For the Next Financial Crisis

"The World Is Deaf" (ou peut-être, 'fou furieux à nouveau' - Jess)