ETF Securities, the London-based issuer of exchange-traded commodities and leveraged funds, is considering expanding the scope of what it is calling “the world’s first third generation ETF platform,” potentially including fixed income ETFs and commodity ETFs on its proposed issuer-specific platform. ETF Securities believes that its new platform, which is being marketed as the ETF Exchange, will have significant advantages over existing forms of ETF platforms:
- First generation ETFs, which track indexes by holding the underlying securities, may incur various costs, such as rebalancing expenses, that result in tracking error.
- Second generation ETFs, which utilize a single swap provider to track an index, are vulnerable to a forced ETF liquidation in the event of a failure of the swap counterparty.
ETF Securities’ proposed platform would utilize multiple swap counterparties in its ETFs, thereby both promoting competitive pricing and ensuring efficient swap replacement in the event of a bank failure.
On Monday, Mark Weeks, the ex-UBS partner brought in to oversee the new exchange, indicated that while ETF Exchange will begin with equity ETFs, it could expand its platform shortly to include fixed income ETFs and exchange-traded commodities as well. Weeks also reported that the new exchange will be a joint venture between ETF Securities and six banks, three of which will be announced in the next week and three of which will be revealed next month.
Exchange of the Future?
ETF Securities is banking on disillusionment with larger ETF issuers and the advantages of its proposed system over traditional ETF platforms to attract investors. If these “third generation” ETF platforms do ultimately prove to be successful, the ETF industry could be altered dramatically. ETF Securities is proposing replacing the current system, which frequently features several issuers offering similar ETF products, with a simplified, more efficient platform with a single ETF for each index. Under such a system, investors could choose from multiple swap providers offering exposure to the index, in theory resulting in increased price competition while maintaining relatively low risk of default through the participation of multiple counterparties.
While such a system has obvious theoretical advantages, there remain several barriers to a successful implementation. Vanguard has recently expanded its UK operations, increasing competition in the European ETF industry. And iShares may be looking to expand the reach of its products following its sale to BlackRock, a move that could make it difficult for the ETF Exchange to establish a foothold. Moreover, by all indications, investors are highly satisfied with the current state of the ETF industry, expressing little desire for change and few concerns over cost structures. Finally, many banks already maintain lines of exchange-traded funds or service existing funds in some capacity, likely diminishing their interest in participating in a system that encourages improved pricing for investors. While these obstacles aren’t insurmountable, I’m betting on these third generation ETF exchanges, including the ETF Exchange and the Source ETF venture being led by Morgan Stanley and Goldman Sachs, experiencing limited success. While an industry shakeup is certainly a possibility, the obstacles to success appear too significant at this stage of the game.
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