So are exchange traded funds (ETFs) the next CDO? That is, are they a likely cause of the next financial crise? Well, its possible that is for sure. Particularly as they are linked in some ways. First of all it is worth pointing something out. Lets imagine I want to set up an ETF that tracks the FTSE 100 stock market. I have two possible options. One is to set up a fund that buys an equal amount of shares in all the FTSE 100 companies. That fund will then track the movement of the FTSE 100 exactly. People can give me money I buy the shares and everyone knows what they are getting. The fund will go up and down with the FTSE 100. This is very simple and its is easy to understand how it works. This is a standard ETF.

Now, lets muddy the waters. Enter synthetic ETFs. An organisation can offer a synthetic ETF that tracks the FTSE 100. The provider of the fund grantees that its value will change in line with the FTSE100. However, the provider can take the money that people invest and put it where ever they like. The idea is that the provider thinks its really smart, and that it can take your money and invest it in such away that it beats the FTSE 100. It has only guaranteed you what the FTS100 makes and therefore it can keep any additional profit.

So in theory everything is great. You get your relatively safe investment fund. The clever people in the bank get more money to invest and make prophet on. The problems come when the bank makes a loss on the investments that they really make with your money. In theory they have guaranteed it, so they have to pay up. This is where things get even more complicated. In order for the bank to take your money elsewhere to invest it they have to put up some collateral in case those other investments do loose money. This collateral is then used to fore fill any obligation to you.  Ok, fine. Its complicated but it sounds sort of ok. However it is the quality of hat collateral that is what scares me and it is scaring other people too.

So lets say that instead of buy FTSE100 shares with your money in my EFT. I setup a synthetic ETF and buy something else. I then put collateral up to guarantee the fund in case I go bust. Lets say I do go bust. You don’t get your share of FTSE 100 companies, you get a share of whatever I put up as collateral. That could be a real mixed bag of sovereign debt, company bonds, whatever really. How would you feel if I had put Greek sovereign debt up as collateral for my FTSE100 EFT?

Things get ever more murky and hard to follow as that collateral could be wrapped up in a nightmare of collateralized debt obligations (CDOs), credit default swaps (CDS), over the counter (OTC) swaps. What would all that mean? Where would you go for your money should I fail? It does start to look like the makes of another credit crisis where know one knows who owes what to who and how much. There are calls to increase the transparency of synthetic EFTs, particularly what the collateral is. I think we need that.

Author: phil

Complex Systems Scientist.