Collateral Explained
Index tracking with limited third party exposure
In order to reduce the tracking error to the benchmark index, some ETF Securities’ products use a swap structure. To minimise credit exposure to swap counterparties products are backed by Eligible Collateral posted by the counterparty. ETF Securities has agreed a set of criteria which apply to all its collateralised products and defines the assets that constitute Eligible Collateral, how those assets are valued and the process for ensuring swap counterparty exposure is collateralised on a daily basis. The Eligible Collateral requirements are consistent with the repo collateral requirements under UCITS guidelines. As a result ETF Securities’ products seek to minimise tracking error with limited credit exposure.
Which issuers use a swap structure?
| Issuer |
Economic exposure |
Swap based |
Credit risk |
ETFS Metal Securities Limited
Gold Bullion Securities
|
Precious metals |
No |
No - all exposure physically backed (metal in vault) |
| ETFS Commodity Securities Limited |
DJ-UBSSM Commodity Indices |
Yes |
Credit exposure against swap providers backed by collateral posted with and monitored by an independent custodian (The Bank of New York Mellon) |
| ETFS Foreign Exchange Limited |
MSFXSM indices |
| ETFS Fund Company Plc |
Equity indices (via UCITs III funds) |
N.B: ETFS Oil Securities Limited is an uncollateralized swap based structure and so the holders have credit exposure to the swap counterparty, Shell Trading Switzerland A.G.
Types of Collateralised Swap Structure
There are two different types of collateralised swap structure used for ETF Securities’ products; however the key collateral characteristics are common across all such products. The two main structures are shown below:
ETFS Commodity Securities Limited (CSL)
Under the CSL structure each swap provider posts Eligible Collateral to a pledge account in its name, held with and monitored by an independent collateral manager, the Bank of New York Mellon (BONY). Each swap provider must contact BONY prior to removing any Eligible Collateral from the account. Exposure to each swap provider is reconciled, mark to market daily, and backed by Eligible Collateral targeting at least 100% of this mark to market value. If the swap provider defaults on its obligations, the issuer (CSL) will take ownership of the Eligible Collateral and realise it (see Credit Event).
ETFS Foreign Exchange Limited (FXL) & ETFS Fund Company Plc (ETFX)
Under this structure the cash held by the issuer (FXL or ETFX) is delivered to the swap provider under a repurchase agreement (Repo) in receipt of Eligible Collateral (to which ETFX or FXL receives legal title). The collateral manager (BONY) will only release the cash to the swap provider upon Eligible Collateral being posted. For FXL the cash inflows are 100% collateralised. There is a daily mark to market of swap exposure. For ETFX, UCITs III rules provide that the maximum exposure to a swap counterparty must be less than 10% of a sub-fund’s NAV. Under our collateral structure we aim to ensure there is no exposure to a counterparty on a given day.
Eligible Collateral
| Type of Eligible Collateral |
Concentration limits and Margin |
| Money market funds: |
Country concentration limit
| U.S.: |
100% |
| UK, Japan, |
| Germany, France: |
50% |
| Others: |
25% |
| |
| Margin |
| < 5 years to maturity: |
100% |
| 5-10 years to maturity: |
101% |
| 10+ years to maturity: |
102% |
| US Agencies: |
102% |
|
| - AAA Government or Treasury money market funds only, with no ABSs nor CDOs |
| Sovereign fixed income |
| - USA |
| - G10 and other European government bonds (with minimum rating of AA) |
| - Supranational bonds with a L-T issuer rating not lower than AAA |
| - US Agencies 100% backed by the US government |
| Equities |
| - Securities have to belong to specific indices. Currently, the Main index names include the major benchmarks such as S&P 500 and EURO STOXX 50, and the Other index names include developed market indices such as NASDAQ and DJ STOXX 600 |
| Per security issuer: |
3.3% or $10 million, whichever is greater |
| |
| For each security |
| Free-float market cap: |
2.5% |
| 30 day ADV: |
100% |
| |
| Country concentration limit |
| U.S.: |
75% |
| UK, Japan, |
| Germany, France: |
25% |
| Others: |
10% |
| |
| Margin |
| Main index names: |
105% |
| Other eligible equities |
110% |
|
The following securities are not Eligible Collateral:
- Securities issued by the swap counterparty or an affiliate;
- Securities subject to corporate actions;
- ABS or MBS.
Collateral lending or rehypothecation is not allowed either.
Credit Event
It is important to note there are different parties involved in the overall issuance and trading process for each of the above structures (i.e. swap provider, issuer, collateral manager and market maker).
In the event of a counterparty default, the Issuer (or the Trustee) would take control of the Eligible Collateral and realise it to attempt to satisfy any amounts owed by the swap counterparty (see credit risk).
In the case of ETFX, the appointment of multiple swap providers allows the sub-funds to continue operating by moving swap balances. BONY, who acts as our collateral manager, is one of the world’s largest custody banks.
Valuation of the collateral
Collateral is valued by the collateral manager (BONY) on daily basis. BONY applies detailed collateral screening and valuation methodology which includes:
- Source the prices from at least 4 data vendors
- Test and validate the price quality
- Remove invalid prices after standard deviation tests and tolerance level tests
- Value at zero any security if the last available price is more than 5 days old
BONY then apply margin and concentration rules.
Collateralisation process
On a daily basis, ETF Securities Limited liaises with the counterparties to collateralise 100% of the reported mark to market exposure:
Daily Process
Important facts relating to the collateral
It is important to understand several facts:
Collateral schedule matters – The holdings of Eligible Collateral posted by the swap providers will change daily. Investors should carefully consider the criteria of the quality of Eligible Collateral as well as the concentration and margin limits that apply.
Credit risk – Eligible Collateral is posted to reduce potential credit risk if the counterparty were to default. The posting collateral does not guarantee that no loss would occur on a credit event. The realised value of the Eligible Collateral following an event of default may differ from the amount owed by the swap counterparty, as prices fluctuate intraday (i.e. from the last point the exposure and collateral were valued). Our collateral schemes apply strict margins and concentration limits to reduce the risk of such a loss, but do not completely remove it.
