The Consortium Model: Paul Amery Interviews ETF Exchange's Mark Weeks

IndexUniverse.eu editor Paul Amery recently interviewed Mark Weeks, head of ETF Exchange, a new exchange-traded fund platform at ETF Securities.

IU.eu: Mark, what is ETF Exchange?

Weeks: ETF Securities has developed and continues to operate a highly successful exchange-traded commodities programme. The company took a decision to try to capture a part of the rapidly developing exchange-traded funds (ETF) market in Europe and we looked at how to improve upon what we call first and second-generation ETFs – those offering direct, in specie index replication and those using swap-based replication via a single swap provider.

ETF Exchange has been developed to address three key concerns in the existing ETF market: first, counterparty risk; second, the lack of liquidity in a lot of existing products; and third, to encourage increased competition in the creation and redemption process. We felt that we could offer improvements in all three areas.

Our model is that of a consortium. We have an independent issuer – ETF Securities – which works with the consortium members (who are the funds’ authorised participants and are therefore responsible for all ETF creations and redemptions). The existing APs are Citigroup and Bank of America Merrill Lynch, but we aim to expand the total to six banks and hope to add two more consortium members by the end of this month. The APs are also the swap providers, so this structure ensures the existence of multiple counterparties for an ETF investor, reducing credit risk. The consortium members also work as distribution partners.

IU.eu: And who owns the platform?

Weeks: ETF Securities owns 80% and hedge fund SW1 Capital owns 20%. There is also the possibility for consortium members to become owners over time, based on the fulfilment of certain performance criteria.

IU.eu: There’s another ETF issuer in Europe with a very similar model to yours – Source. Are there any differences between the two platforms?

Weeks: There are some differences. First, we’re an independent issuer, meaning that from a commercial perspective we’re not competing with financial products offered by partner banks; second, we have our own independent sales force of over 20 people, rather than relying on the sales forces of the consortium banks (even though we work closely with them); and third, at the end of the day, ETFs are a cheap way of replicating index performance and require a low-cost operation such as ETFX.

IU.eu: What has motivated your choice of ETFs? You started out with commodity-related equity funds and some broad equity indices but have since added a suite of double leveraged and double inverse funds. Aren’t you concerned by the recent controversies over leveraged ETFs?

Weeks: We saw a niche in the market for the double long and short funds and decent investor demand for them. So far the assets under management have grown quite well and they’re also used a lot by day traders, creating some decent trading volumes. The controversy over leveraged funds in the US has made a number of issuers step back and think twice about getting involved in this area of the market, but we feel that as long as you are clear in the prospectus about what the ETF does and what index it tracks, and as long as this is presented very clearly to clients, then these can be good products to be involved in.

IU.eu: There seems to be quite a split in Europe between those issuers offering short exposure in a packaged format (via inverse/short ETFs) and those promoting short selling of “long” ETFs. What do you make of this?

Weeks: I don’t think it’s as easy to short-sell ETFs as some people make out in their marketing literature. Borrowing an ETF to short isn’t straightforward. You only have to talk to some of the ETF market makers to hear how high the fees can be for doing this, for a start. They can be hundreds of basis points, which is much higher than the fee of a typical short ETF. In my old world of securities finance, all these ETFs would have been called “specials”. Short ETFs also reduce your overall risk – you can’t lose more than your initial stake, for example, whereas you only have to look at what happened to Volkswagen shares last year to realise how risky a margined short position can be. Finally, access is still a big issue. As a retail investor you can gain short exposure to many markets through short ETFs, whereas the stock borrowing market is primarily accessible only to hedge funds with a prime brokerage account and to certain institutions.

IU.eu: What other areas of the ETF market are you looking at getting involved in?

Weeks: One of the theories behind the platform structure is that the consortium banks will lead product development and come up with a steady stream of new fund ideas. In reality, we will probably drive this process since relying on the consortium banks would likely result in the creation of new funds with a strong equity focus. Why? Because the banks involved in the ETF platform earn money primarily from two sources: first, from the provision of swaps and, second, from making use of inventory through securities lending. On average, equity inventory is of greater value to a bank than fixed income inventory because it generates more revenue in lending fees.

A lot of prime brokers have seen the ETF business as a great way of extending their own in-house swap business (which is financially attractive) and at the same time as a way to build inventory and not have to rely on institutions to source stock when they want to borrow it.

It’s worth reiterating that none of this affects the ETF investor from a risk perspective since it represents the banks’ hedge position, but it explains some of the commercial dynamics behind the evolution of the business.

IU.eu: Are swap-based ETFs then generally more profitable from the issuers’ perspective than in specie ETFs? For a start, they tend to be collateralised to a lower extent – swap-based ETFs have to have a minimum 90% collateral backing under UCITS rules, whereas in specie ETFs tend to be overcollateralised if any securities are lent out.

Weeks: I’m not sure about profitability, but we overcollateralise all our swap-based ETFs. We take a basket of securities from the swap provider, consisting of either government debt with no margin, main index equities with a 5% margin or non-index names with a 10% margin. So we have up to 110% collateral backing for each ETF and in fact we have the same overall collateral profile across all our products, including ETCs, with Bank of New York as the triparty collateral manager.

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