Risk

OTC-Type ETF Credit Risk

Update : Oct. 29, 2012

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1. What is OTC Derivatives trading (OTC Swap-type ETF)?

A primary example of ETFs which invest in OTC Derivatives trading is the OTC Swap-type ETF. OTC Swap-type ETFs utilize a management method which aligns the fluctuation rate of the net assets per unit with that of an underlying index by concluding a total return swap agreement which exchanges the returns of the underlying index between the ETF issuer and primarily financial institutions.

Though OTC Swap-type ETFs do not experience tracking errors, they do involve the credit risk of the counterparty to the swap agreement.

2. OTC Swap-type ETF Credit Risk and Notes when Investing

Many OTC Swap-type ETFs involve both parties to the swap agreement contributing collateral. This mechanism allows for avoidance of loss in the case of one party’s bankruptcy through the exchange of such party’s collateral. However, in the case of bankruptcy for one party to the swap agreement, because the exchange of returns from the underlying indicator are halted, the fluctuation rate of the ETF’s net assets per unit tracking that of the underlying indicator cannot be maintained. As a result, the base value of the ETF may decline.

Additionally, there may be cases where the exchange value is not the same as that of the collateral, depending on the type. As a result, the value of the ETF may decline or be nullified.
When investing in OTC Swap-type ETFs, it is important to confirm the financial health of the parties to the swap agreement and maintain a sufficient understanding of such parties’ credit status.

Mechanism of General OTC Swap-type ETFs

Mechanism of General OTC Swap-type ETFs

  • (*)Actual exchange of cash/securities is conducted by a trustee company (trust bank) under the direction of the ETF issuer.

There are 15 OTC Swap-type ETFs listed on TSE, including the S&P GSCI® Capped Component 35/20 THEAM Easy UCITS ETF Class A USD Unit (Code: 1327) and the ETFS Commodity ETFs (Codes: 1684 – 1697, Total: 14 issues). These issues employ several measures to reduce credit risk including: not exchanging collateral between swap agreement counterparties, separately managed swap agreement counterparty collateral and grant the right to retrieve collateral in the event of their bankruptcy, and limiting deposit of collateral to highly exchangeable products, such as US Treasuries.

Example of OTC Swap-type ETF Risk Reduction Measures

Example of OTC Swap-type ETF Risk Reduction Measures

  • (*)Actual exchange of cash/securities is conducted by a trustee company (trust bank) under the direction of the ETF issuer. The financial institutions which are counterparties to the swap agreement are disclosed in the Securities Reports. When investing, please make a note of such information.

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