Celent expects that there will continue to be a global trend of increasing volume for physical ETFs in the Asian markets, but it does not necessarily expect a booming future there for synthetic ETFs. In a recent white paper, “Synthetic ETFs in Asia-Pacific: A Losing Battle?” Senior Analyst Anshuman Jaswal makes the case that the Asian market “might struggle to grow at the same pace in the future.” It appears that much will depend on the unfolding consequences of recent action by Hong Kong’s regulators, and by ongoing deliberations in Singapore.
The U.S. remains the largest market for exchange-traded funds. A figure on global ETF cash flows published by Bloomberg shows that investors poured $100 million into U.S. based ETFs. A little more than half of that was invested in equity based funds; most of the rest had fixed-income underlying. Europe had a cash flow of $30 million and Asia Pacific just under $20 million.
Europe is in the lead in the development of the synthetic ETF market. In the U.S., only 3 percent of ETFs are synthetic. In APAC, it is 11 percent, while in Europe it’s 37 percent.
Looking at those distinctions from the point of view of annual issuance, we again see Europe’s dominance. In 2010, Europe accounted for 87 percent of global issuance of these products, the US for just 6 percent.
Europe is dominant, author Jaswal suggests, because the UCITS regulations create investor comfort. Under the UCITS regime, the daily net asset value “of the collateral basket, which can include cash or equities and bonds of OECD countries, has been stipulated to cover at least 90 percent of the ETF’s NAV, limiting the swap counterparty risk to a maximum of 10% of the ETFs market value.”
Synthetic ETFs are products that use derivatives, such as swaps, to imitate the behavior of physical ETFs.
On the one hand, the synthetic nature of these products makes them less expensive than physical ETFs. On the other hand, “there are concerns that the exposure to derivatives products such as swaps … can lead to greater counterparty risk for the investor.”
The Two Hub Cities
Geographically, the twin focus of the synthetic ETF market in Europe is Hong Kong and Singapore, and the main providers in those two cities are Deutsche Bank and Lyxor (a wholly-owned subsidiary of French bank Société Générale). They copy the recipe for success from Europe. More than 70 percent of the authorized investment funds in those cities are now UCITS-compliant.
Hong Kong’s regulator, the Securities and Futures Commission, has moved just over the last few months to assert an imprint on the synthetic ETF market, increasing collateral requirements and enhancing transparency, especially for retail investors. Specifically, ETF managers “will now be required to achieve at least 100% collateralization to ensure there is no uncollateralized counterparty risk exposure…” In other words, the new Hong Kong rule is tougher than the UCITS 90 percent rule. As to transparency, managers will be required to publish the collateral policy, and the overall collateralization levels and related information, on their websites.
Lyxor, which has 12 ETFs of HKEx, recently announced plans for their delisting. Celent says that this may be a tie of cause and effect: trading volumes may not be adequate to make Lyxor’s ETFs cost-effective given the new measures.
Singapore is different. There, some of the synthetic ETFs involve considerably more exposure to uncollateralized counterparty risk than the 10 percent or less that UCITS would allow. Singapore has, for example, the iShares MSCI India tracker, which has a 20 to 25 percent exposure. The regulator there is “considering” a toughening of the rules. But Celent sees a possibility that laxity will prove a winning move vis-à-vis Hong Kong: “in the case that regulatory changes in Singapore are not as tough as those seen in Hong Kong, Singapore could become the center for synthetic ETF trading in Asia.”
Without quite putting it this bluntly, Jaswal seems to be making two related points. First, standards more lax than UCITS scare away investors. Second, standards more strict than UCITS may deter management. Thus, for the sake of continued growth of the market, UCITS compliance, sans more, may prove best.
Finally, the paper warns that there are systemic risks in the nature of synthetic ETFs and collateralization. In a future crisis, large simultaneous withdrawals from ETFs could raise correlation, and volatility, in the global capital markets quite sharply. This is, in other words, yet another narrow doorway in the system, and the problem with narrow doorways is that they don’t work if a lot of people want to leave at once.This article was originally published on AllAboutAlpha under the title: Future of Asia’s Synthetic ETF Market May Lie With Singapore Regulators
Tags: banking , China , equity funds , ETF & Indexing Investment Summit 2011 , ETFs , Financial Markets , Hong Kong , Singapore , stock markets