Assessing ETF counterparty risk

[scottish]

Hiho,  I was reading this thread in general discussion:  http://forum.mrmoneymustache.com/welcome-to-the-forum/buying-individual-stocks/ and a couple of people commented on counterparty risk.   I believe this to mean the risk that the company sponsoring the ETF, i.e. Blackrock, goes bankrupt.

Anyone have any thoughts on how to assess this risk?   As I understand it, the ETF itself consists of creation units which are large baskets of shares that replicate the ETF structure.  Creation units are created/destroyed by market makers when the ETF price diverges from the value of the ETF holdings, creating an arbitrage opportunity.   The creation units are divided up into the shares that trade on stock exchanges.

This sounds reasonably clear in theory, but I'm not sure how it would work in practice.   If Blackrock were to file for bankruptcy, what would happen to all of these things?  Presumably the value of the ETF remains, since the creation unit has purchased the basket of equities.   It's easy to imagine the value of the ETF starting to diverge from the index it's tracking.  How far would it diverge?   How would the shareholders liquidate their holdings?

[protostache]

Following.

I guess I would think that if Blackrock were to file for bankruptcy, that wouldn't include the shares held in trust for the ETF. Thus, they would either do a one-time in-kind distribution to ETF holders, or some other big bank would swoop in and buy the right to manage the trust.

There are other types of counterparty risk as well. For example, some (maybe most?) ETFs will lend out the underlying securities to margin traders. How much of this transfers to ETF holders I have no idea.

[dmn]

The counterparty risk is not so much that your ETF provider could go bankrupt. Since the stocks in the ETFs belong to the investor (you), they would not be lost in that case, provided that your ETF provider actually upheld the law. The ETF's counterparty risks are mainly fraud, securities lending and derivatives contracts.

Fraud:
There have been cases in the past where investment firms or their employees secretly and illegally sold their customers' assets to pay their bills, e.g. to avoid bankruptcy. In that case, your stocks might be gone and you would have to sue the investment firm, hoping that there is enough money left to pay for the money value of your lost stocks. In some countries, there are (limited) government insurance schemes against this risk.

Securities lending:
Most ETFs lend their securities to hedge funds for short-selling. The hedge fund pays a small lending fee to lend your stocks e.g. for a week. It sells the stock immediately, and hopes to buy it back after a week at a lower price to return it to your ETF. However, if the hedge fund goes bankrupt in between, your stock will not be returned. For this reason, the hedge fund has to leave some collateral at your ETF. Losses occur only if the hedge fund goes bankrupt *and* the collateral loses value at the same time, which might happen during times of great market turmoil.

Derivatives:
Sometimes, ETFs invest part of their money in derivatives instead of buying stocks. These derivatives are issued by some bank; if the bank goes bankrupt, the invested money in the derivatives can be lost. As for securities lending, there might be some collateral, but it is not guaranteed that this collateral will keep its value.

[NoStacheOhio]

The counterparty risk is not so much that your ETF provider could go bankrupt. Since the stocks in the ETFs belong to the investor (you), they would not be lost in that case, provided that your ETF provider actually upheld the law. The ETF's counterparty risks are mainly fraud, securities lending and derivatives contracts.

Fraud:
There have been cases in the past where investment firms or their employees secretly and illegally sold their customers' assets to pay their bills, e.g. to avoid bankruptcy. In that case, your stocks might be gone and you would have to sue the investment firm, hoping that there is enough money left to pay for the money value of your lost stocks. In some countries, there are (limited) government insurance schemes against this risk.

Securities lending:
Most ETFs lend their securities to hedge funds for short-selling. The hedge fund pays a small lending fee to lend your stocks e.g. for a week. It sells the stock immediately, and hopes to buy it back after a week at a lower price to return it to your ETF. However, if the hedge fund goes bankrupt in between, your stock will not be returned. For this reason, the hedge fund has to leave some collateral at your ETF. Losses occur only if the hedge fund goes bankrupt *and* the collateral loses value at the same time, which might happen during times of great market turmoil.

Derivatives:
Sometimes, ETFs invest part of their money in derivatives instead of buying stocks. These derivatives are issued by some bank; if the bank goes bankrupt, the invested money in the derivatives can be lost. As for securities lending, there might be some collateral, but it is not guaranteed that this collateral will keep its value.

Wouldn't most of these be covered by SIPC?

[protostache]

Wouldn't most of these be covered by SIPC?

SIPC covers you if your brokerage fails. It doesn't protect you from one of your holdings failing, be it a bond, stock, ETF, mutual fund, whatever. SIPC came about because back in the 1970s there was a spate of brokerages going insolvent and being unable to deliver on trades.

[dmn]

Wouldn't most of these be covered by SIPC?

As I understand it, SIPC would cover fraud (up to 500k $) but not losses due to securities lending or derivatives counterparty failure. The last two are investment decisions: ETFs use them because they generate extra income or reduce costs during good times, but that extra income is a risk premium to compensate for the chance of losses. This is not insured, just as losses due to a stock market crash are not insured.

Also note that the American SIPC scheme is more generous than most other countries' rules. For many non-US investors, fraud will also not be covered.

[scottish]

Very good, thank you.    I spent some time researching this at lunch as well.   My ETFs are very straightforward and they don't have significant holdings of derivatives.  They're all run by Blackrock, so hopefully the corruption is at a minimum.   This leaves me with two scenarios:
1.  Blackrock collapses for some reason.   The ETFs retain most of their value.   Trading may be suspended until things are sorted out.   Low probability of occurrence, low impact if it does happen.
2.  Blackrock collapses due to extensive internal fraud.    This scenario would have the most impact, but is very unlikely.   The impact would depend on the extend of the fraud.

Scenario 1 is easy to mitigate.   Just keep 12 months worth of withdrawals somewhere else.
Scenario 2 is not so easy to mitigate.   Split my holdings between 2 ETF companies?   But it seems very unlikely, so maybe it's not worth taking action.

Incidentally Canadian coverage for brokerage failure is at $1M CAD.   (There's a bit more to it than that, it seems to be $1M for unregistered account and $1M for registered account.)   I don't think they have enough funds to pay out on a widespread basis though.

[dmn]

@scottish: I think you miss securities lending in your list. Blackrock is very active in that regard.

To summarize:

(1) In the past, they have lent out up to 50% of their assets. Now they scrapped even that limit, so they are not guaranteed to actually hold any stocks at any given moment.
(2) They recently reduced the amount and quality of collateral required for securities lending.
(3) They keep 37.5% of the profit from securities lending (which explains the upper two points), giving only 62.5% to the ETF investors.

Blackrock says they will reimburse investor's losses from securities lending, but I do not know if this is legally binding, and it is clear that blackrock has very limited capital compared to the volume of their ETFs.

[scottish]

Yes I did miss that.  Thank you very much.   Blackrock says that their ETFs are allowed to loan up to 1/3 of their assets.

linky:  https://www.blackrock.com/investing/literature/brochure/securities-lending-unlocking-portfolios-en-us.pdf

Hmmm, they also assure their investors that they require 102% cash or cash equivalents as collateral.   I'll need to go and think about this.

[dmn]

Yes I did miss that.  Thank you very much.   Blackrock says that their ETFs are allowed to loan up to 1/3 of their assets.

Thank you for the link. I was not aware that the SEC only allows up to 33% lending ratios in the US. You really have much better financial industry regulators than we have in Europe!

Hmmm, they also assure their investors that they require 102% cash or cash equivalents as collateral.   I'll need to go and think about this.

I am not sure how broadly they interpret "cash equivalents", but they do mention money market funds. These are relatively safe, though European regulators keep worrying they might get into trouble in severse crises. (Their structure currently allows something like a bank run on the fund in case of minor losses, leaving the last investors with exacerbated losses after most investors pulled out their money at 100% of its nominal value.) As with the securities lending, I am not sure about the US regulations on that topic, maybe the SEC has imposed stricter rules.

[cerat0n1a]

The various Blackrock ETF prospectuses that I've seen in Europe have a bit for each one which describes whether that particular ETF is "Physical" (where they buy & hold the shares) or "Synthetic" (where the index in question is tracked through derivatives/swaps).

[bacchi]

Man Financial collapsed due to massive internal fraud.

MF Global experienced a meltdown of its financial condition, caused by improper transfers of over $891 million from customer accounts to a MF broker-dealer account to cover losses created by trading losses.

The good news is that more than 95% of assets were returned. The bad news is that it took years.