A review of the structure and risk management rules for swap-based ETFs

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In this article, I will outline the structure of BNP Paribas Easy synthetic ETF products and explain how counterparty risk is managed, both in terms of management company and group levels.


Full versus synthetic replication

In indexed portfolio management, the portfolio manager can choose to replicate the performance of the underlying index by investing in physical securities or through derivatives.

Physical replication means the exchange-traded fund (ETF) holds all index constituents in exactly the same proportion as the index.

Synthetic replication on the other hand means the index’s performance is imported using total return swaps. In this case, the fund receives the index performance, adjusted for the swap spread, from the swap counterparty. In return, the counterparty receives the performance of the fund’s substitute basket.

Choice of replication method depends on the index being chosen

Both the physical and synthetic replication methods have their pros and cons. Based on the underlying index characteristics, our replication experts will choose the most appropriate method, i.e. the one that is most cost-efficient.

A swap-based approach will be preferred to full replication in instances of difficult market access or tax constraints, or so as to optimise transaction costs for large indices. Around half of BNP Paribas Easy assets are managed using full replication, the other half using a synthetic approach.

In swap-based synthetic replication, the ability to negotiate swap terms is of the utmost importance. Long-standing business relationships with core reliable counterparties, the amount of assets under management and a well-established auction process are the added-value features of our synthetic replication offering.

Competitive pricing is not the only evaluation criterion for the choice of a provider for an OTC transaction. At the fund management level, all providers are continually evaluated regarding their credit risk, accuracy of valuations, reactivity, etc.

Here is an overview of our swap–based ETF investment process

Fund structure: an unfunded swap model

The fund’s assets are invested in a basket of securities, the performance of which is swapped against the index performance, adjusted for the swap spread. This basket, called the ‘substitute basket’, comprises:

  • Eurozone large-cap stocks for all synthetic equity ETFs, making them PEA[1] eligible for French investors
  • US T-bills with a duration of around three months for our commodity ETF
  • Global large-cap stocks for MSCI Emerging Markets SRI. We do not select securities which are excluded under BNP Paribas Asset Management’s sustainable investment sector policy, or those with an ESG ranking of decile 7 to 10 (from 1 to 10) by BNP Paribas Asset Management’s Sustainability Centre.

When selecting the securities for the substitute basket, we favour liquidity over their correlation to the reference index.

Exhibit 1: Synthetic replication process

Exhibit 1: Synthetic replication process

Open architecture

For BNP Paribas Easy products, we can enter into a swap agreement with one or several parties, thereby diversifying credit risk. We select swap counterparties via an open architecture bidding process that allows us to obtain highly favourable market conditions.

The funds conclude swaps only with counterparties authorised by our Global Counterparty Committee, which applies strict criteria to investment banks. Counterparties will be chosen only from eligible institutions, based on their expertise in the underlying asset class/strategy, the competitiveness of their price offering and the quality of valuations and services provided. We are currently working with seven counterparties.

Risk control measures

All BNP Paribas Easy products are UCITS compliant and thus benefit from the EU’s product regulation. According to the UCITS directive, exposure to OTC derivative counterparties cannot exceed 10% of the fund’s net asset value (NAV), thus limiting credit risk to 10% of the ETF’s assets. As well as filtering the list of authorised counterparties, our risk management policy encompasses features aimed at carefully controlling counterparty risk.

Swap reset policy

To continuously ensure the swap market value does not exceed 10% of the fund’s assets, ETF portfolio managers ask to reset the swap when there is a subscription or a redemption, but they can also ask to terminate the swap agreement at any time by activating the early termination clause at no extra cost.

A safe collateral policy

For our ETFs that use swap-based replication, the counterparty risks are offset by the use of collateral (100%).

The collateral is in cash only and the settlement is daily.

What if a counterparty defaults?

In the event that a counterparty is unable to meet its obligations, the loss incurred by the ETF will be limited to the marked-to-market value of the swap, less the collateral daily value.

Under the unfunded swap structure, the substitute basket and collateral holdings held by the fund’s custodian are owned by the ETF.

Thus, should a default occur, the fund manager can decide either

  • to realise the assets and switch to physical replication
  • to close the fund and repay investors
  • to enter into a new swap agreement with another counterparty.

As a counterparty default is highly correlated with a distressed market environment, our policy is to hold liquid assets in both the substitute and collateral baskets so as to be able to liquidate them instantly.

Conclusion

Our swap-based investment model aims to:

  • Offer cost-efficient replication of indices whose physical replication is not ideal because of difficult market access or tax constraints, thanks to our open architecture swap-bidding process, which ensures cost competitiveness among swap providers
  • Diversify credit risk by using multiple counterparties
  • Apply stringent controls at all levels, from the authorised counterparty’s list validation to daily operational checks by our investment, collateral and risk management teams.

[1] PEA – Plan d’Epargne, or shared savings plan that is tax-efficient in France


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Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients.

Gregory Guerrand

Investment Specialist

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