Thursday, April 22, 2010

Synthetic securities are not so strange

Original posted on Interfluidity by Steve Waldman:

Synthetic securities are not so strange. Many retail investors own them.

If you hold a commodity ETF or a equity ETF that tracks its benchmark via futures, you hold a synthetic security. Like a synthetic CDO, commodity and equity ETFs are investment vehicles that hold very vanilla “collateral securities” (like Treasury bills), but simulate exposure to some other thing by taking positions in derivative markets. For example, if you were to purchase the PowerShares DB Agriculture ETF (DBA), you would hold an interest in an entity that holds T-bills and takes futures positions in commodities like corn, wheat, and sugar. Despite the fact that this entity is synthesized in part from “zero-sum” derivatives, your shares of DBA constitute “securities” in every common sense: They are standardized, transferrable, claims on a business entity. The fund holds assets (the T-bills) that serve to secure claims that may arise against it in the course of doing business. Shares are limited liability instruments; investors can not be held liable for amounts beyond what they have invested.

It is possible to borrow and sell short shares of DBA, but at the fund level, the statement “for every long there is a short” is no more true of DBA than it is of IBM. It is true that the long futures positions held by the ETF are necessarily matched by short positions by some other investor. Formally, the short counterparty is likely a single clearinghouse. But the clearinghouse is just an intermediary; in an economic sense, the positions opposite DBA are held by a wide variety of market participants whose motivations may include both speculation and hedging, who may or may not have information or strong beliefs about future price movements.

The fact that DBA is “synthetic” may or may not have economic significance. If you review the prospectus of a synthetic ETF, you will be informed of various risks relating to the structure of derivatives markets. But the ETFs are intended simply to offer exposure to a basket of commodities more efficiently than a fund that physically warehoused the goods would. Commodity ETFs track the experience of an entity holding real goods with varying degrees of accuracy, but most investors view their positions as simply being long the commodity.

There are lots of important differences between a commodity ETF and a synthetic CDO. Synthetic CDOs are usually leveraged. Some synthetic equity ETFs are also leveraged, although they manage leverage very differently. Unlike ETFs, claims on synthetic CDOs are divided into multiple tranches, which is intended to create different classes of shares that are more or less speculative. The derivative positions held by synthetic CDOs are usually over-the-counter credit default swaps, and are likely to be less liquid than the futures positions held by a typical ETF.

I don’t mean to overstate the analogy. A synthetic CDO built from credit derivatives on the hard-to-digest bits of mortgage-backed securities is very different from an ETF that provides exposure to commodities. To the degree that it is important to draw inferences about the nature and intentions of a fund’s counterparties, one would conclude that the CDO and ETF trade with very different populations. A synthetic CDO is constructed in a manner intended to provide stable and predictable cashflows to more senior investors. Commodity ETFs are volatile all around.

However, the statement “a XXX transaction necessarily included both a long and short side” is as true for commodity ETFs as for synthetic CDOs. That statement may or may not have some economic significance. But it does not in itself imply that there are one or a few counterparties taking concentrated speculative bets specifically against the holdings of the fund.

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