ETF: Deutsche Bank ETF panic

Kristia van HeerdenETF Blog, Latest

South African ETF investors looking for offshore exposure have had a convenient vehicle in the Deutsche Bank x-tracker ETF products. We have been supporters of these products, both through personal investments in x-tracker ETFs and by recommending the ETFs to our users.

Last week the global financial system was rocked by speculation that the German bank might face insolvency. Speculation about the bank’s impending doom has spooked many investors, including Team Just One Lap. In the last JSE Direct podcast, Simon Brown shared his views on the impact of Deutsche Bank’s troubles on ETF investors. In this post, two of our regular ETF contributors share their views on what might happen to Deutsche Bank ETF holders.

As always in financial markets, nobody can predict the outcome with certainty. Pretending that turmoil at the issuer won’t affect investors at all is naive, but it’s probably also not necessary to gear up for the apocalypse. Below we present both takes. Consider the facts and do some more research on your own before making a call on this one. Panic often leads to muddled thinking. Remember, your money is your responsibility. Know why you’re making your choices.

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Keith Mclachlan – AlphaWealth

This is a difficult one because it has three answers, two of which no one wants to hear:

1.) Theory

In theory, the ETF is underpinned by real assets that the investors hold. It doesn’t matter what happens to Deutsche Bank, for the investors will still hold the underlying assets. In this case, stocks.

2.) Reality

Deutsche Bank ETFs underlyings do not have attached claims (that we are aware of) if it goes under. But Deutsche Bank both administers and market makes for these instruments. Therefore, in the very least, the ETFs intra-market liquidity will disappear instantly and so potentially will its back office administration (all paid for by Deutsche Bank). In time, this administration of both market making and back office will pass on to someone else (perhaps another bank will “buy” it on liquidation auction or something), but that will almost certainly not be instantly.

This creates two problems:

  • The liquidity of the ETF on the JSE will drop dramatically, its spreads widen and its mark-to-market price volatility spike ridiculously (if the JSE doesn’t just simply suspend it completely until the administrative details above are assumed by someone else)
  • Inflows, outflows, in specie, S42 and other transactions with the ETF will be difficult to do (or impossible) as there may be no one there to do them

Reality is more complicated than theory and we really don’t know what contingency plans Deutsche Bank has (if any) for service level agreement (SLA) handovers.

3.) Harsh reality

If Deutsche Bank goes under, we will likely be thrown back into a (hopefully, short-lived) financial dark age. Markets will collapse (or at least sell-off aggressively over a period) and there will be a serious number of knock-on effects that are hard to track. For example, Deutsche Bank’s derivative book is larger than the GDP of the EU itself, thus unwinding it or missing a counter-party margin call will push massive downside out into the system and someone will have to absorb that. Do yourself a favour and read about Long Term Capital Management (LTCM) and their derivative book that unwound in the 90s. Deutsche Bank’s derivative book makes LTCM look like a rounding error!

What I am saying is that markets will do really, really badly if Deutsche Bank fails, and that includes all the long-only ETFs out there.

So, even if you can transact in Deutsche Bank ETFs shortly after an implosion of Deutsche Bank and your underlyings are still there, the odds are that your underlyings will not be worth quite as much as they are now. Combine widened (or non-existent) spreads from minimal (or zero) market making in Deutsche Bank products, panicking investors and collapsing values in the underlying and you get a very nasty picture what Deutsche Bank’s ETFs could do in this scenario…

Mike Brown –

Exchange-traded products (ETPs) are fully regulated and listed products that have a multitude of factors built in to ensure that investors are not compromised if the issuer of an ETP product happens to enter difficult times, or even go out of business.

Deutsche Bank, as the largest bank in Europe, is not going to be allowed to fail.  Even if it was technically insolvent, which it isn’t, the European Central Bank (ECB) or the German authorities, would step in to manage the bank. Just like Gordon Brown nationalised some UK banks in 2008 and the Fed did the same in the USA, etc.

An ETF is a statutory investment product, in the case of Deutsche Bank, registered under UCITS regulations (the European and UK equivalent of the Collective Investments Schemes Act) and regulated as a public company on stock exchanges. The regulations require that the ETF be 100% physically backed and the assets held in an insolvency remote Trust, under control of Trustees independent of the issuer of the ETF. The Deutsche Bank ETFs are also registered under the Collective Investment Schemes Act in South Africa and have a special local management company set up for this purpose.  In effect, ETFs are JSE listed unit trusts and have all the investment protection of a unit trust.

The Deutsche Bank ETNs, listed on the JSE, including the Deutsche China ETN, are issued out of a fully physically backed UCITS regulated fund in Europe. The liability is also 100% covered, and Deutsche has issued this as an ETN rather than an ETF because it is easier and cheaper to issue an ETN in SA than an ETF.

The ETNs are therefore no more risky than ETFs and are JSE listed securities, so liquidity is always available on the JSE, or through the market maker, who has to make a price at the NAV of the product.

So if Deutsche Bank was taken over by the German Government and nationalised, which would only happen if there was a run on its deposits, the new owners would have a statutory obligation, in terms of UCITS (CISCA) and stock exchange legislation, to honour the terms and conditions of these products. As they are fully covered liabilities, there would be no cost to them in covering this obligation.

If they decided not to continue with ETPs (very unlikely), then the Trustees of the ETF/ETN would then liquidate the portfolio and pay out the unit holders the full value of their investment.

The in-specie swap facilities, whereby you can exchange the underlying basket of index basket securities for the ETFs in issue; the open-ended redemption/creation of new units on the JSE; the “arbitrage” options of the market makers and the issuer of the ETFs, etc. all ensure that the ETF/ETN always trades at its NAV.  The price of the ETF/ETN is not determined by the health or otherwise of Deutsche Bank and its share price, it is determined by the intrinsic value or NAV of the index.

This is all a bit of a storm in a tea cup and seems to be largely confined to South Africa, rather than other markets in the world where ETFs are a much larger component of the investment markets.

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