Synthetic ETF
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A synthetic ETF is an investment that mimics the behavior of an exchange-traded fund (ETF) through the use of derivatives such as swaps.[1]
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ETF structures
There are broadly speaking two main structures for ETFs. Physical ETFs are “plain-vanilla” products that replicate the index by simply reconstituting the basket of physical securities underlying the index (e.g. the basket of S&P 500 stocks) with appropriate weight.[note 1] They are the dominant form of ETF ̧ especially in the US and are mainly provided by large independent asset managers.[2]
Synthetic ETFs allow replication of the index using derivatives as opposed to owning the physical assets.[3]
One popular synthetic structure involves the use of total return swaps,[note 2] which the ETF sponsors refer to as the unfunded swap structure (Figure 2). Under the synthetic replication scheme, the authorised participant receives the creation units from the ETF sponsor against cash rather than a basket of the index securities as in the physical replication scheme. The ETF sponsor separately enters into a total return swap with a financial intermediary, often its parent bank, to receive the total return of the ETF index for a given nominal exposure. This constitutes the first leg of the swap. Cash is then transferred to the swap counterparty equal to the notional exposure. In return, the swap counterparty transfers a basket of collateral assets to the ETF sponsor. The assets in the collateral basket could be completely different from those in the benchmark index that the ETF tries to replicate. The total return on this collateral basket is then transferred to the swap counterparty, which constitutes the second leg of the total return swap.[3]
(insert Figure 2)
Types of Risks
- Counterparty risk
- Collateral risk
- Liquidity risk
- Conflicts of interest
Notes
- ↑ To limit transaction costs due to the rebalancing of index components, physical ETFs generally hold a sample of the securities composing the index rather than the full basket. The resulting basis risks related to the physical ETFs’ index tracking quality are generally managed from the revenues that the ETF derives from securities lending.
- ↑ A total return swap is a bilateral financial transaction where the counterparties swap the total return of a single asset or basket of assets for periodic cash flows, typically a floating rate such as Libor.
See also
References
- ↑ Synthetic ETF Definition | Investopedia, viewed June 10, 2014.
- ↑ Potential financial stability issues arising from recent trends in Exchange-Traded Funds (ETFs)
- ↑ 3.0 3.1 Market structures and systemic risks of exchange-traded funds, BIS Working Paper No. 343, April 2011, from Bank for International Settlements (BIS)
External links
- Potential financial stability issues arising from recent trends in Exchange-Traded Funds (ETFs), 12 April 2011, from Financial Stability Board
- Global Financial Stability Report, Durable Financial Stability, Getting There from Here, April 2011, from International Monetary Fund (IMF). ETF discussion starts on page 68.
- Market structures and systemic risks of exchange-traded funds, BIS Working Paper No. 343, April 2011, from Bank for International Settlements (BIS)
- Too Much of a Good Thing, The risks created by Complicating a Simple Idea in The Economist, June 23, 2011, retrieved June 27th, 2016.
Forum Discussions
Blogs
- A Game-Changer, from IndexUniverse
- Synthetic ETFs could pose a threat to global financial stability, say regulators, from Monevator
- How a synthetic ETF works, from Monevator
Periodicals
- The rise of synthetic ETFs, from Financial Times, subscription required. (UK)
- Now the IMF is warning about ETFs, from Financial Times, subscription required. (UK)
- Too much of a good thing, The risks created by complicating a simple idea, from The Economist
- Regulators Consider Ban On Retail Purchases Of Synthetic ETFs, from ETF.com - Europe
- Regulators Consider Ban On Retail Purchases Of Synthetic ETFs - Features , from ETF.com - Europe