More derivative witch hunts

November 17, 2009 in Finance

Going through the FT's original post on exchange traded currency notes, I saw a couple of sentences that really bothered me. One thing we do not need right now are witch hunt statements without basis (a point especially compounded by the fact that the FT completely misunderstood how these products worked, even as they wrote a piece describing them):

First:

In quick conclusion, the ETCs appear to be another fine example of how exchange-traded products are mutating from their transparent replication-based beginnings into ever more complex instruments.

Granted, an ETC isn't going to be as easy to understand as SPY. But that doesn't mean it's "out to get" investors. Remember when Seeking Alpha tried to help people lose money even faster with FAZ and FAS?  Now those were truly frightening derivatives - leveraged, options and/or swaps based plays with complex end of day delta-balancing schemes. These ETC's are nothing compared to that. In fact, they're no more terrifyingly complex - and much less manipulable - than the commodity ETFs Alphaville covers so frequently. Yes, they're the first currency ETFs (sorry, FT insists that it's wrong to confuse these for ETFs, even though they don't say why). Get over it.

Second:

The type of financial whizz-kidery that brought us CDOs, meanwhile, appears to be thriving well in ETFs.

I don't even know where to start with this one. Maybe the author wrote this because the word "collateral" appears frequently in the prospectus. I wonder if it's the same financial whizz-kidery that brought us secured loans and mortgages, too? What is this sentence doing here, besides making people associate these products with those that ruined the financial system? We're talking about total return indices on the deepest, most liquid market in the world - not distressed CDO tranches.

Third (regarding Morgan Stanley, the derivative counterparty):

Morgan uses the proceeds it receives to hedge its total-return-swap exposure — but essentially can do whatever it pleases with the money.

What does this really mean? Morgan Stanley might be fooling investors, opting to take their cash elsewhere rather than hedging their exposures? Well in that case, Morgan Stanley is taking on currency risk equal and opposite to those investors; so it's not exactly a free trade. One of two things must be true:

  1. MS doesn't want currency exposure. In this case, they have two options: they use the ETC proceeds to hedge their currency risk OR they "steal" the ETC proceeds and use cash from elsewhere to hedge the exposure. The economic outcome is identical.
  2. MS wants currency exposure. Again, two options: they use the ETC proceeds to hedge their currency risk, after which they put on the desired currency exposure OR they "steal" the ETC proceeds and pray that the ETC investors in aggregate have taken the exact opposite viewpoint from the one MS wants to take. Since option two is extraordinarily unreasonable and volatile, there's really only one option here: hedge the currency risk with the ETC proceeds.

Fourth:

Bank of New York Mellon has the responsibility of monitoring the eligibility of the collateral, but to all extents and purposes, from what we can make out, Morgan Stanley determines the valuation on a daily mark-to-market basis.

Another piece of conspiracy-bait. Fortunately, FT lays out what that collateral can consist of: "AA-rated G20 government bond, AAA-rated shares of government or treasury money market funds, AAA-rated supranational bonds, unsubordinated bonds issued by Ginnie  Mae and any equity listed on 'specified indices' anywhere in the world" (and I'm going to hazard that adding "anywhere in the world" is yet more bait, since the "specified indices" are major ones in developed economies). Let's call it like it is: Morgan Stanley is not going to be able to make up their own arbitrary marks, thereby cheating the investor out of their collateral backing, on these deep and liquid securities. In any case, they are disincentivized to do so (as FT reveals in the next paragraph) by a set of over-collateralization rules.

Fifth:

As for the investor — remembering the products were launched as a response to investor demand for “secure, transparent and liquid currency package”– it means a potential upside scenario of receiving all of the performance of a currency index, for relatively low management fees, but without any interest or dividend (no carry trade here then) and downside scenarios that include credit-exposure to Morgan Stanley, covered by a claim on potentially illiquid securities, as valued by Morgan Stanley. Compulsory redemptions at inopportune moments due to a myriad of different triggers.  And in the event of counterparty default, a position third-in-line for repayment.

Right off, the carry trade claim is simply wrong. Moreover, these are total return indices, so there ARE all the benefits of interest and dividends - they are just reinvested rather than distributed. The downside scenario is correct that this gives some credit exposure to MS, but the "potentially illiquid" line goes a little too far. I know that the prospectus says that these securities might not have a deep secondary market, because it has to, but in default they are extraordinarily liquid - they represent claims on FX derivatives! There's no uncertainty about what they are worth in default.

Sixth:

ETF Securities’ ETCs are based on Morgan Stanley’s MSFX Total-Return Currency Indices. The way they achieve that performance, however, is not by replicating the components of those indices, but by taking out a total return swap with a counterparty that assures the performance of that index.

In ETF Securities’ case that counterparty happens to be Morgan Stanley (and only Morgan Stanley for the time being).

Again, misplaced suspicion. Here's a scenario: to get exposure to the S&P 500 I can either 1) use cash to buy all 500 stocks and actively manage their exposure every day, making sure to reinvest dividends or 2) enter a total return swap which tracks the level of the actual S&P 500, plus dividends, perfectly. (There's a third option, which is to buy SPY - effectively paying someone to do option one on my behalf.) Which one has a lesser chance of error? (Hint: it's the swap.) Yes, a TRS is a derivative - but it's not evil by that virtue. It's exactly the same as a vanilla interest rate swap, the most liquid derivative in the world, only it reference the level of the S&P 500 instead of Libor. So let's not get all suspicious of these crazy methods for replicating payoffs.

I'm not going to pretend that these ETCs are vanilla securities. They carry risks - perhaps large ones - and will likely experience liquidity difficulties until (and if) their market attracts traders, just like any security. No, I haven't read the prospectus, and my comments are based purely on the FT post; moreover, my concern regards the FT's attitude rather than the securities themselves. I can't endorse any sort of derivative witch hunt of this sort - its unfounded, based if anything in popular fears that themselves were borne out of ignorance (on the part of both retail investors and institutions). It may be in journalistic vogue, but it's hardly appropriate here.

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