Evolution of Swap Based ETFs_SNUGLIFAD_0810_EN

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Evolution of Swap Based ETFs_SNUGLIFAD_0810_EN

4 The Evolution of Swap-Based ETFsThe Evolution of Swap-Based ETFs 4The mechanics of swap-based ETFsIn contrast to the straight forward nature of physical-based ETFs itis important to understand the different types of swap-based ETFsand their structure, in the order of their entry into the market.There are four basic structures, which we will be referring to asPhase 1, Phase 2.1, Phase 2.2 and Phase 3. The four structureswill be assessed with respect to the key areas of counterparty risk,best execution for the client and transparency.Phase 1: Swap-based ETF with a single swapcounterparty and an uncollateralised swap exposureThe first swap-based funds were set up where the single swapprovider to the funds was an affiliated bank of the ETF provider. Underthis model the fund buys and holds a basket of securities from theswap counterparty. These holdings are often referred to as a referencebasket and typically do not contain the securities of the index.At the same time the fund enters into a total return swap agreementwith the swap counterparty, which exchanges the performance ofthis reference basket for the performance of the benchmark indexadjusted for the swap spread. The swaps are generally reset on amonthly basis. See Figure 4.The banks determine the securities that they sell to the fund (withinUCITS regulatory requirements) and thus look to sell to the fundassets on the banks’ inventory that are of a lower quality than thosethat they would need to purchase to hedge themselves in order topay the fund the index return. This is known as an inventory upgradetrade. This results in a positive economic return for the banks andallows them to pay index return to the fund with low costs. Howeverthis puts the ETF investor at risk of being left with illiquid or difficultto trade securities in the event of a swap counterparty default.Typically transparency around the fund’s holdings has been low andthus the investor cannot analyse or quantify the risks embedded inthis fund structure.From a funds perspective, the main objective is to keep therunning costs of the ETF to a minimum and to satisfy UCITSdiversification requirements.Figure 4: Structure of a swap-based ETFAuthorised ParticipantInvestment Bank AIndex Return +/- Swap SpreadCash(1)Swap Counterparty(2)Investment Bank ACashBasket of Securities(3)ETFReferenceBasketBasket ReturnSource: BlackRock. For illustrative purposes only.www.iShares.com • ISHARES

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