Derivative instruments may entail counterparty credit risk for investors

A Hong Kong-based financial analyst has warned that local A-share exchange-traded funds (ETFs) could pose a risk similar to that of the Lehman Brothers minibond fiasco which erupted in the wake of the 2008 financial crisis. Capital Focus Asset Management Director Simon Luk warned that the ETFs have adopted derivative instruments that may entail counterparty credit risk for investors.

The city's Securities and Futures Commission (SFC) also issued a stark warning in July when they stated that not all ETFs track market performance directly as some of them adopt synthetic replication strategies that invest in over-the-counter derivatives, which also brings counterparty credit risk to the fore.

The funds, which trace A-share indices, are gaining popularity among local investors as they are seen as a good bet on the mainland's capital market. However, some of the funds are not as straightforward as all that. Some ETF replication strategies do not just invest in the composition of the underlying A-share index, but rather hold financial derivative instruments to generate returns that involve greater financial risks.

One example of this is the iShares A50 China Index ETF. Issued by Deutsche Bank, they use derivatives to generate returns that are equivalent to holding the underlying A-shares. However, these ETFs have adopted collaterals, such as the H-shares issued by mainland companies, in order to provide a cushion against severe market downturns.

In the case of the iShares A50 China Index ETF, the investor does not hold A-shares directly but rather holds Chinese A-shares Access Products (CAAPs), issued by financial institutions that utilize the investment quotas allowed to Qualified Foreign Institutional Investors (QFII).

Capital Focus Asset Management's Simon Luk warned that in the case of a dramatic downturn in financial market sentiment, ETFs could pose counterparty credit risk to investors on a scale as big as the Lehman Brothers minibond fiasco.

"If the financial institutions that issue these CAAPs collapse, then the values of these ETFs will be wiped out. Default risk is really the prime concern that investors should pay attention to," Luk told China Daily.

"As the fund manager of the iShares A50 China Index ETF has complex transaction structures with various counterparties, credit risk will be magnified. The credit risk involved may be more complex than ordinary investors can comprehend," Luk added.

He also advised that local investors should study the counterparty risk involved before investing in ETF products.

Another ETF fund manager, BlackRock Asset Management North Asia Limited, has entered transactions with 12 investment banks that issued CAAPs under QFII investment quotas. Under the current rules, these investment banks should only issue CAAPs supported by their QFII quotas, but the reality is that they may use leverage to issue more CAAPs than are supported by QFII quotas.

SFC has also issued a word of caution. It stated that the strategy of credit risk diversification through the acquisition of financial derivatives from numerous counterparties may lead to greater risk exposure because "the more counterparties an ETF has, the higher the mathematical probability of the ETF being affected by a counterparty default."

SFC added that even though some ETFs have pledged collaterals in a bid to reduce counterparty default risk, there is still a very large chance that the market value of the ETFs may be significantly reduced.

According to SFC's own statistics, it authorized 65 ETFs as of the end of July. Of the total, 49 of them have adopted synthetic replication strategies.

ETFs are also becoming increasingly important in investment portfolios. According to the BlackRock ETF Landscape Industry Review, there were 2,252 ETFs issued by 130 providers listed on 42 exchanges around the world in the second quarter of 2010 with total assets amounting to $1,025 billion.

China Daily

(HK Edition 09/23/2010 page3)