Interview: Multi-Counterparty Model and Liquidity

Source's Michael John Lytle discusses the appeal of the multi-counterparty model and liquidity in the European ETF market

Ben Johnson 25.08.2010
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We recently spoke with Michael John Lytle, Director of Marketing for Source to discuss the firm’s recent success in attracting new assets, its liquidity-centric approach, and the merits of using multiple swap counterparties for synthetic replication funds.

According to Deutsche Bank research, Source witnessed approximately EUR 2 billion in net cash inflows during the second quarter. This ranks first amongst all European ETF providers and has helped Source to climb to the number eight spot in Europe ETF league table—as ranked by assets under management.

The Appeal of the Multi-Counterparty Model
Source’s liquidity-centric approach to constructing its funds and its approach to creating value for investors has attracted the attention of many hedge funds that formerly used over the counter (OTC) swaps to get sector exposure. In fact, according to Lytle, “We think that we have moved perhaps 50% of the outstanding OTC sector swaps into our ETFs”.

What’s the appeal of investing in Source’s equity sector ETFs versus using sector swaps? Having a choice of trading partners is one benefit. As Lytle explains, “[with] an OTC swap, the investor is basically locked into trading with the bank who put on the trade when they want to unwind the position.”

Source’s ETF business features a multitude of trading partners including BofA Merrill Lynch, Credit Suisse, Goldman Sachs, J.P. Morgan, Morgan Stanley, and Nomura who participate in trading with the funds along with 16 other named market makers. This model gives large investors more latitude when trading than offered by traditional OTC swaps. As Lytle puts it, “now they can trade with one bank going in and a different bank on the way out”.

What about the fact that Source has multiple counterparties to the swaps it uses to create its synthetic replication funds? Where does this rank in order of importance in the minds of current clients? Lytle ranks this feature behind the ability to engage multiple trading partners, “For former investors in OTC sector swaps, the ability to trade with multiple counterparts is number one. Being able to buy a cash instrument is number two and two ‘B’ is what’s in that cash instrument and ‘how much exposure do I have to any one counterparty?’”

As for the specific appeal of the multiple counterparty model to institutional investors, Lytle adds, “When former OTC swap counterparts looked at us from a counterparty perspective they said: ‘Okay well effectively what you’re going to do is take over the back office function that we’re managing. Instead of us having to send and receive collateral on a daily basis, you’re going to manage a basket of listed equities, hedge with swaps and then you’re going to manage the exposure to the banks that write the hedge. Now, if Source were using one bank, that’s sort of the same as what we’re doing today though still operationally lighter. However, as soon as you do it versus multiple banks, that’s better than what we’re doing today, and we get it for free, because we don’t have to expend any further operational resources. So, we’ll take that. That’s great.’”

The notion that having multiple counterparties to swap-based funds reduces counterparty risk is a hotly debated topic. Critics of this claim (put forth by platforms like Source and ETF Securities ETFX) highlight the fact that UCITS rules allow a fund that engages multiple counterparties to take additional levels of credit risk--capped at 40% of a fund’s net asset value. Meanwhile, synthetic ETFs featuring a single swap counterparty must maintain their credit exposure to the swap issuer at less than 10% of the fund’s net asset value.

In practice, both single-counterparty and multi-counterparty funds manage their counterparty exposures to much lower levels (for more on the various provider’s policies please see this article). According to Lytle, “We’ve capped our exposure to all swap counterparites at 4.5% which in effect means that we have to cap our exposure to any individual bank at significantly less than that.” However, more importantly, Source--like many other providers--resets the swaps in its funds upon every creation or redemption of fund shares with its partner banks. Depending on how liquid the fund in question may be--more liquid funds will likely see more frequent creations/redemptions and vice versa, this practice serves to further reduce investor’s exposure to swap counterparties. As the liquidity of Source’s funds has increased, average exposures have become increasingly small. According to Lytle, “The average counterparty exposure we’ve had on our funds during 2010 is about 15 basis points.”

To us, the maths seems simple: more counterparties will result in less counterparty risk. Could counterparty exposure in a multi-counterparty model theoretically exceed the UCITS-mandated 10% maximum in an ETF featuring a single swap counterparty? Yes. Will this ever be the case in practice? We doubt it. Doing so would undermine one of the key selling points boasted by the likes of Source and ETFX, and frankly we don’t think investors would tolerate such a practice. Finally, should this be one of the primary considerations for investors considering similar ETFs? Hardly. While minimising the risk of permanent capital impairment is paramount, the differences between the ways in which most major ETF providers manage this risk are not amongst what we would consider to be the top three differentiating factors when shopping for ETFs: fees, liquidity, and tracking.

Source has built its ETF product offering with liquidity in mind. Its sector ETFs track the STOXX Europe 600 Optimised Supersector indices. These indices are designed to exclude the least liquid and most difficult to short constituents of their plain-vanilla benchmarks in order to increase liquidity. The firm has also limited its exchange listings for each of its products to one venue--either the Deutsche Borse or the London Stock Exchange--in order to consolidate its on-exchange volume.

While this model has been fairly successful, on-exchange turnover in Europe remains at fairly low levels, and over two-thirds of ETF trades continue to take place on an OTC basis--effectively taking the “E” out of ETF.

Lytle attributes this in part to the current ETF market structure. On the one hand, there are market makers like Nyenburgh, LaBranche, and FlowTraders operating on the exchanges. According to Lytle, these market makers, “are very aggressive and efficient but generally have limited trading capital compared to the large investment banks. As a result, they tend to not put up very large sizes on the exchange, but they can be pretty nimble in small sizes.” Without a deep order book to deal in on-exchange, large investors have preferred to trade OTC, creating a classic problem.

“You end up with this chicken and egg situation. The global investment banks only want to do the work required to make markets on exchange if there are significant flows to tap or their institutional clients are absolutely insisting that they trade on the exchange. Alternatively, if they start seeing institutional size flow across the exchange that they wouldn’t have seen otherwise it is also appealing. Someone has to make the first step and drive liquidity to the exchange and we are working on that with our partners”, states Lytle.

So in essence, ETF liquidity will improve once ETFs become more liquid. If this sounds discouraging, that’s because it is. However, the picture isn’t as grim as it might first seem. While average daily turnover of ETFs across the major European exchanges--as measured as a percentage of ETF assets--is still roughly one ninth of the level of daily turnover in the US ETF market, the trend is encouraging. In the second quarter, on-exchange ETF turnover increased 69%, according to Deutsche Bank research. So while there is still ample room for improvement, liquidity is certainly improving in the European ETF marketplace.

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Ben Johnson  Ben Johnson is Morningstar’s Director of European ETF Research.

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