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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
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
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
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 & share||Indexing|