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Replication strategies for exchange-traded funds

This article is part of
Guide to Exchange-Traded Products

“The quality of the collateral and over collateralisation helps investors to protect from counterparty default risk.”

The first swap-based ETFs were launched in 2001, according to iShares, and involved a single counterparty underwriting the swap. The swap exposure was limited to 10 per cent of net asset value in line with the Ucits rules.

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According to iShares this model lacked transparency in the fund’s holdings (the reference or substitute basket), which are often purchased from the fund promoter’s investment bank affiliate, and it carried undiversified counterparty risk exposure.

To address counterparty risk, a spokesman for iShares says the next generation of swap-based ETFs were introduced at the end of 2008. The structure used multiple swap counterparties, which allowed diversification of counterparty risk.

A spokesman for iShares says: “Having multiple swap counterparties can decrease the costs of the swap as counterparties are not affiliated with the ETF provider and compete with each other on monthly swap spreads.”