This is a continuation of my previous post, The Dangers of Synthetic ETFs.
If you refer to the Products Highlight Sheet or prospectus of a synthetic ETF, they will spell out clearly what are the risks involved in the product. So investors will not be able to say that such risks were not disclosed to them if something happens.
This is how one example of how the swap counter-party risk portion can look like :
The Manager currently enters into swap agreements with a swap counterparty in order to essentially exchange the Fund’s exposure to the Basket of Balance Sheet Assets (or any other assets as may be held by the Fund) with an exposure to the Benchmark Index.
The swap agreement(s) entered into by the Fund are subject to the risk of default by the swap counterparty on its obligations. The current swap counterparty for the swap agreement(s) entered into by the Fund is xxx.
If such a default were to occur, the Fund will have contractual remedies pursuant to the agreements related to the transaction. In the event the Fund enters into funded swap agreements with the swap counterparty(ies), the counterparty risk exposure will be reduced due to the collateral arrangements which will be taken in relation to such funded swaps.
If such a default were to occur, the Fund will have contractual remedies pursuant to the agreements related to the funded swaps to realise the collaterals provided by the swap counterparty(ies). However, such remedies may be subject to bankruptcy and insolvency laws which could affect the Fund’s rights as a creditor.
For example, the Fund may not receive the net amount of payments that it contractually is entitled to receive. Nevertheless this risk is limited as the Fund is subject to a counterparty limit of 10% of its NAV on a single counterparty. In other words, whilst the Fund may notionally invest an amount constituting up to 100% of its NAV in financial derivative instrument(s) in accordance with the UCITS Directive, the Fund is subject to a maximum single counterparty risk exposure of 10% of the NAV of the Fund in relation to the swap transaction entered by the Fund.
The 10% might give some sense of re-assurance to investors, but one thing for sure in the event of a default by the swap counterparty is that any resolution will take time (possibly months or even years).
And then there is also this portion on custodian risk which you might come across:
A Fund’s assets are held in custody by the depository and where applicable the assets pledged in favour of a Fund are held in custody by third party custodian(s) and/or sub-custodian(s). This exposes the Funds to a custody risk. This means that the Funds are exposed to the risk of loss of these assets as a result of insolvency, negligence or fraudulent trading by the depository and/or third party custodian(s) and/or sub-custodian(s).
Don’t be mistaken that buying an ETF is safer than buying a single stock as it is more diversified because in reality, there could be significant counter-party risks.
Because if you search hard enough, you might realize that in some ETFs, the manager, market-maker, swap counterparty and custodian all belong to the same party. 😯