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Stingy Investor Tip Sheet

ETF Counterparty Risk

The crash of 2008 sent a hoard of once-mighty financial institutions to the graveyard. Even worse, the problems that infected them spread. The hunt is now on for anything that may have been touched by counterparty risk, which rears its head when banks fail. Some investors are even looking farther afield and are starting to worry about their exchange traded funds.

Before diving in, what is counterparty risk? Simply put, it is the risk that someone will stiff you on a deal. For example, your hungry friend says that he'll pay you Tuesday for a hamburger today. If you give him money for the hamburger, he might not actually repay you on Tuesday. Most people will accept this small bit of counterparty risk. After all, the bond of friendship will likely lead to prompt payment. (Wimpy excepted.) The situation can change when it comes to larger sums and strangers.

In the world of high finance, counterparty risk crops up in many places. The over-the-counter derivative market, where firms make complicated deals, is a problem area. Everything works as expected provided the firms remain in operation. If one firm goes bankrupt, the previously arranged deal might not survive a bankruptcy court.

The problem is very real for institutional investors but some individuals have also been burned. For instance, owners of Lehman Brothers principle protected notes (PPNs) were recently mauled by counterparty risk. These notes were designed to give investors some stock market upside with a guarantee that they'll get their money back should the market fall over a period of time. The market declined and investors are looking for Lehman to pay up. Problem is, Lehman is bankrupt and the firm isn't paying. To say that these PPN investors are upset is an understatement. Their plight also inspired us to look for counterparty risk in other popular investment products owned by main-street investors.

We turned our gaze to Canadian exchange-traded funds (ETFs). Are such funds exposed to counterparty risk? Yes. But before you run for the hills, the risk in this case seems quite modest.

Stock ETFs tend to hold stocks directly. Some also use exchange-traded futures contracts to transform cash into index holdings. The futures trade on exchanges and they are backed up by a clearing corporation which is very unlikely to default.

The more serious counterparty risk crops up in ETFs that employ forward contracts to hedge their currency exposure. Here we're thinking of ETFs like iShares CDN MSCI EAFE Index Fund (TSX:XIN), iShares CDN Russell 2000 Index Fund (XSU), and iShares CDN S&P 500 Index Fund (XSP). These ETFs are hedged against currency movements. For U.S. ETFs, that means changes in the Canadian-US dollar exchange rate don't impact fund returns. To cut costs, the ETFs hedge using forward contracts. Unlike futures, forwards are not exchange-traded. You can buy them from a big bank but you could suffer should the bank collapse.

That got us looking into the banks that iShares uses for their currency hedging program. The nice iShares people were kind enough to pass on a current list of their counterparties. They include, Bank of America (Canada), Bank of Montreal, Bank of Nova Scotia (and Scotia Capital), CIBC (and CIBC World Markets), HSBC Bank Canada, RBC (and RBC DS), and TD. To our knowledge, none of these banks is close to collapse. Indeed, it seems very likely that any big Canadian bank would be rescued before it went under. But we might have said the same thing about Lehman Brothers not too long ago.

We also note that iShares spread their hedging program across several banks which provides a level of diversification. Several banks would likely have to fail before really hurting unit holders. Overall, the ETFs appear to have done a good job of guarding against counterparty risk.

We can't help but point out that investors would have been better off without the currency hedge in recent months. So, the ETFs are likely shipping money to the banks to payoff the hedges. In this case, the banks are rather unlikely to renege on the deal.

Counterparty risk can be a big deal. We just don't think iShares' TSX-listed ETFs suffer from a significant amount of it. Indeed, one might be more worried about the exposure of the individual stocks in the index to counterparty risk. But that's a story for another day.

10/31/2008   11:44 PM EST   Permlink   save & shareIndexing

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