New Naming Rules For Synthetic ETFs in Hong Kong
Outside of new launches, the main news last month concerned the imposition of new naming rules on synthetic (derivatives-based) ETFs in Hong Kong. These funds will now have to carry an asterisk after their name, followed by a footnote indicating that they are a synthetic ETF – for example, the “iShares FTSE A50 China Index ETF* (*This is a synthetic ETF)”. In November 2010 the local authorities had already required that the short version of a synthetic ETF name must also be preceded by an X, as in the “X iShares A50”.
What’s the Hong Kong regulator worried about? Almost three years after the Lehman collapse, public officials are still sensitive to criticism over the “minibonds” fiasco, when around 30,000 people were left with losses on credit securities linked to the failed investment bank. As a result the normally laissez-faire SFC seems to be paying much closer attention to what gets marketed to retail investors. In fact the new naming rules follow an investor education effort last summer warning about counterparty risks in synthetic ETFs; this was obviously considered insufficient.
The exchange-traded funds most likely to use a synthetic structure are those accessing the mainland China A share market, where foreign ETF managers are unable to invest in local shares directly. Instead, they have to buy derivatives called China access products (notes issued by third parties, typically banks, who have been awarded quotas to invest in A shares).
Synthetic ETFs marketed in Asia by some providers, such as db x-trackers and Lyxor, have stuck to the UCITS rules that apply to their European-listed funds. These rules limit the total uncollateralised counterparty exposure of any fund to 10% of its net assets. However, many of the China A-share products on offer from other providers have much higher levels of naked exposure to derivatives counterparties.
The Hong Kong Securities and Futures Commission’s (SFC) code on unit trusts and mutual funds includes rules on counterparty quality and collateral. But these are weaker than Europe’s UCITS rules: exposure can be 10% of NAV per counterparty. Given that many A share products have multiple counterparties, a fund can have substantially more uncollateralised exposure than UCITS would allow. In the case of the Hong Kong-listed iShares A50 fund, the largest A share tracker in the world, total net (uncollateralised) exposure to derivatives counterparties is currently around 75% of the fund’s value.
But apart from the imposition of new naming rules for all derivatives-based funds, tougher limits for those funds that operate with relatively high levels of uncollateralised exposure don’t seem to be on the agenda at present in Hong Kong.
In fact Hong Kong isn’t the first Asian market to require such upfront disclosure of fund structure. Synthetic replication came to Australia late last year in the form of BetaShares’ new products, and the Australian Stock Exchange’s rules include an obligation to carry the word “Synthetic” in their title. On counterparty exposure, the ASX appears to be more in line with UCITS standards, with a total limit of 10% for naked counterparty exposure via derivatives.
No other Asian markets have brought in similar rules yet, although Singaporean authorities are consulting on amendments to their fund code, which might in turn lead to some changes in local regulations. The situation is perhaps less pressing here than in Hong Kong, since majority of Singapore-listed synthetics are UCITS III compliant structures from db x-trackers and Lyxor.
However, there are a couple of exceptions in Singapore: a China A share ETF from UOB and an iShares MSCI India tracker. Both of these actually have rather high uncollateralised counterparty exposure. The iShares fund says it seeks to limit exposure per counterparty to 20-25%, while the UOB fund uses a rather unusual structure that would seem to have uncollateralised exposure of up to two-thirds of net asset value.
In the much larger markets of Korea and Japan, physical replication continues to rule the day. In Korea, the only non-physical products are a few leveraged and inverse ETFs that use futures. Japan has a handful of ETFs that invest in overseas markets through index-linked notes. The Tokyo Stock Exchange’s listing rules says that managers must monitor the creditworthiness of counterparties, but lays down no rules on collateral levels and the ETFs don’t appear to take any (or don’t disclose their net position if they do).
In most other Asian markets, the suitability of synthetic ETFs for all investors has yet to become an issue since the line-up consists almost exclusively of physically replicated funds. However, both Thailand and Taiwan have feeder ETFs for a synthetic A share fund in Hong Kong, and Malaysia has a feeder for a non-synthetic fund in Singapore. If this method spreads – which would perhaps make sense as a way to bring greater variety to smaller markets – new regulations in Hong Kong and Singapore could have cross-border consequences.
