Europe has had the highest levels of synthetic exchange-traded fund (ETF) issuance in the world, according to a new report by financial research firm Celent.
With the market growing swiftly between 2006 and 2010, Europe has become the leading global market for synthetic ETFs and almost 90% of synthetic ETF issuance in 2010 occurred in Europe, the report found.
Synthetic ETFs mimic the behaviour of a physical ETF through the use of derivatives and proponents say they are better and faster at tracking indices.
But the instruments have been criticised for their lack of transparency and complexity in design and are the target of an investigation by the European Securities and Markets Authority (ESMA), the securities watchdog for the region.
“Synthetic ETFs seem to be cheaper than their physical counterparts, which partly explains their popularity,” said Anshuman Jaswal, a senior analyst at Celent. “However, there are some concerns regarding their economic impact.”
The report noted that because a number of ETF providers were affiliated with leading European banks, they posed a higher risk due to the use of possibly illiquid collateral being provided by the affiliated bank.
Another issue with synthetic ETF collateral management was that the composition of the collateral can be very different from the composition of the underlying index supposedly being replicated. While this is not always a problem, in the case of a crisis or high level of redemption, the situation could lead to higher counterparty risk than anticipated.
Other international markets – particularly in Asia – have been wary of the instrument. In Hong Kong, the Securities and Futures Commission (SFC) seemed to have softened its stance on synthetic ETFs, approving in the last few weeks a number of products in Deutsche Bank’s db X-trackers series.
Marking the first time the SFC has approved a synthetic ETF since 15 July 2010, Deutsche Bank’s new instruments trade the MSCI China, India, Indonesia, Malaysia, and Thailand total return net indices.