Why bother spending time on counterparty risk?

Let’s face it, it’s unlikely counterparty risk is the most appealing topic for fund selectors. This is not an area which will trigger high level talks about the fate of the European currency or the rise of the emerging consumer.

Nor will it bring right away to the selection team a higher esteem. In a nutshell, assessing counterparty risk is neither fun nor socially rewarding. But still, whether you are investigating into hedge funds, ETFs or regular Ucits, failing to spot a counterparty issue can make a whole lot of difference.

Counterparty risk is different from other risk factors in its very nature and it should pop up on selector’s check list at several levels. The very difference between counterparty risk and most other risk is its likelihood and potential impact.

Typically, market risks tend to materialise rather often but their immediate impact on the returns are mostly smoothed over time: tracking errors and betas do change but usually shift slowly rather than exploding abruptly. On the other hand, a failed counterparty is highly unusual, but what it would mean for an investment makes a major difference.

Most market risks are linear. Counterparty risk is binary, Boolean: it’s about make or break, passing or failing, nothing in between.

Taking care of it is somewhat similar to insuring your car: the vast majority of your life, it’s costly and useless. But at some point, you will be so happy having paid for so long.

Synthetic ETFs have grabbed much attention, for quite some time now. In this space, counterparty risk is obviously taken care of. Or, to put it more precisely, it’s been under greater scrutiny for the past couple of years, in the aftermath of the 2008 systemic fears.

Providers have become much more transparent about how they handle it and who they are dealing with. Thus, investors can assess more accurately what part of their investment could be exposed to one particular institution.

Obviously, having counterparties selected within or outside the fund manager’s group can make a meaningful difference, as far as costs, and this has to be investigated. But still, the debate is heating up so much that a proposal appeared in order to spin off synthetic ETFs from others Ucits.

More recently, investment banks, backed by some academics, fought back, explaining that physical replication carries as much counterparty risk as synthetic. True, as this technique often involves security lending, counterparty risk is as meaningful as in swapped ETFs. Except for the handful of ETF houses who do not lend the securities they’re holding.

When it comes to regular Ucits, counterparty risk might lie in several places. The custodian is the obvious place, as they are making sure client’s money really is where it is supposed to be.

The trick is that custodians are banks, and you may have noticed that, these days, several banks are having a hard time. But the good news is, even when custodian banks have been in serious trouble over the past couple of years, the funds they had the custody of, emerged un-affected.