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The announcement by the bank that it is preparing to impose negative interest rates on wholesale deposits is a classic sign of deflation.

Attempts by governments and central banks to force economies out of recession appear to have failed. Both conventional methods (cutting rates) and unconventional ones (quantitative easing) have been tried, and neither has borne fruit.

“In its grand...experiment the Fed pushed rates to zero, flooded the world with cash, then expected banks to lend and businesses to expand. Did it work?” asks Mish Shedlock.

“Clearly not,” he answers. “No-one wants to put that cash to use. If you were a business would you be hiring here? I wouldn't, and neither are businesses. Instead cash sits in banks or short-term treasuries earning zero or even negative percent.”

Banks only want to lend to creditworthy customers, says Shedlock, while the only clients who want to borrow are the riskier ones. The result is stalemate.

The imposition by BNY Mellon of negative deposit rates came as US government bill yields hit zero and the rate on overnight repurchase agreements (repos) went below that threshold, according to a report in the Wall Street Journal.

BNY Mellon has seen large inflows of cash from its institutional customers, which it then has to park in assets like T-bills and in secured deposits. If it’s having to pay to do so (via negative rates), it wants to be able to pass this cost on to clients. If it holds the cash on its own balance sheet, the bank has to pay higher capital charges and extra costs for deposit insurance.

What happens next? Negative rates make the hoarding of cash even more likely. That equates to a further slowdown in monetary velocity and, necessarily, in economic activity.

Below-zero interest rates threaten instability elsewhere. The US money market fund model of not allowing values to drop below a dollar a share, or to “break the buck”, would become completely unsustainable under such circumstances. Perhaps it’s not coincidental that last week saw the second-largest outflows ever from this type of savings vehicle, according to a Lipper report from yesterday.

Will the US government step in again to underwrite money market funds’ NAV at US$1, as it did in 2008? After the recent battles over fiscal policy, this seems less certain. And, according to a Moody’s report, cited last year in the Wall Street Journal, financial support from money market funds’ managers themselves might be less forthcoming than it was in 2007-09, when firms pumped in a total of US$12 billion to prop up valuations. If these funds, which are used as alternatives to bank accounts by many Americans, do break the buck, deflationary expectations will become entrenched.

Gold and silver have been unsurprising beneficiaries of the current market instability, even though Thursday saw a sharp late-day sell-off in both. Negative money market interest rates don't sound like bad news for precious metals, though, and the end of their bull market still seems some way ahead.

As for the equity markets, where analysts have, until very recently, been expecting a rise in the S&P 500 index’s earnings by 17% this year and another 13% in 2012, to new records, a deflationary economy will require...let’s just say, some adjustments to forecasts.

The success of US-listed exchange-traded funds tracking the domestic debt of emerging market economies has prompted European issuers to follow suit.

As my colleague Oliver Ludwig wrote yesterday on our sister site, IndexUniverse.com, Market Vectors’ Emerging Markets Local Currency Bond ETF (NYSEArca: EMLC) and WisdomTree’s Emerging Markets Local Debt Fund (NYSEArca: ELD) are right on trend with investors at the moment, having gathered a collective US$1.5 billion in assets since their launches last year.

On this side of the Atlantic, we’ve seen two similar funds appear in 2011, and I hear that more are in the pipeline. A few months ago SPDR Europe launched its Barclays Capital Emerging Markets Local Bond ETF (Xetra: SYBM), while iShares released the Barclays Capital Emerging Market Local Govt Bond ETF (LSE: SEML) in June. Each fund now has over US$50 million in assets.

According to Jan van Eck, head of Van Eck Global, the managers of EMLC, recent concerns over European default and the US debt ceiling only serve to reinforce the attractions of the local currency debt of developing economies.

“Couple the [debt] issues in the US with [the ratings] downgrades that have already taken place in developed Europe, and contrast that with emerging market countries that have worked to strengthen their economic policies and to improve their credit profiles, and emerging market local currency bonds look potentially quite appealing,” Mr Van Eck told the Financial Times for an article published yesterday evening.

But is this the right time for investors to be gaining access to the sector? I think not.

Why? First, buying local currency emerging market debt right now means purchasing currencies that, in some cases, are severely overvalued.

Take Brazil, which constitutes 17 percent of iShares’ SEML and 10 percent of SPDR Europe’s SYBM. According to the Economist’s Big Mac index, Brazil’s real stands out by some way as the world’s most overvalued currency (by 52 percent on a “raw” basis, converting the cost of a Big Mac in reals to that in US dollars using the current FX rate, or by 149 percent if you adjust for differences in GDP between the two countries).

If you prefer a less flippant measure of valuation, the IMF has been saying the same thing for a while, while Brazil's finance ministry has been discouraging capital inflows through successive hikes in taxes.

Other emerging market currencies may not look so expensive, says the Economist, even if in most cases they are not particularly cheap, either.

However, there’s a second reason for caution on the valuation of domestic emerging market bonds. Many countries in the ETFs launched over the last year face inflation problems, meaning that rates should be heading up, rather than down.

According to Philip Poole, head of investment strategy at HSBC Global Asset Management, key emerging market economies like Russia and India are too slow in raising rates to combat domestic inflation. Further, says Poole, quoted in Hedge Fund Review, emerging market inflation pressures are more deep-seated than commonly thought, arising from high capacity utilisation levels and low unemployment rates, and not just as a result of recent commodity price increases.

One bullish case for emerging market currencies is that rising interest rates may attract more inflows from abroad, pushing FX rates higher. Of course, if you’re also investing in the local debt markets you’ll suffer capital losses as rates rise. But chasing local currencies higher in overheating economies where interest rates are rising is a risky game to play, as such trends are likely to end in a rapid reversal.

The appearance of local currency emerging market debt ETFs is good news for investors, as this is a useful new asset class for issuers to cover. But I’d be wary of buying this sector now, near what could be a top in emerging bond markets’ valuation.

According to analysts Jon Maier and Elias Lanik of Bank of America Merrill Lynch, it doesn’t really matter what a synthetic ETF holds as collateral.

“It is our opinion that the issue of collateral is only relevant in the event of a counterparty default,” said Maier and Lanik in their recent report, A better understanding of synthetic ETFs.

“While we are a proponent of full transparency of the underlying collateral basket, we are not necessarily of the belief that it is problematic to have a mismatch of the underlying collateral versus the fund’s benchmark,” the analysts continued.

In our investigation of Eurozone government bond ETFs, we found that different providers of synthetic ETFs, tracking indices that were almost equivalent, used quite different portfolios for their substitute baskets.

db x-trackers’ Eurozone government bond fund owned a portfolio of government bonds that resembled, give or take a few percentage points in country weightings, the index itself. Lyxor’s fund had a lot of agency, municipal and covered corporate bonds, plus some sovereign debt. Amundi’s ETF had more government bonds than Lyxor's, but with a lot of volatile, long-dated, zero-coupon securities among them, plus a big overweight in Italy. And Comstage used a basket of Eurozone equities, plus a few German government bonds, to collateralise its swap.

One astute observer has pointed out to me today that, if db x-trackers is using a substitute basket that resembles the index being tracked, isn’t this effectively physical replication? That would be an unexpected consequence of synthetic ETF providers taking a more conservative approach to collateral policy.

But if you look at the four ETFs I’ve just described, in the opinion of Maier and Lanik there’s nothing much to choose between them, as long as their substitute baskets are UCITS-compliant. You’d then, I suppose, choose between these funds on the basis of total expense ratio, tracking performance and secondary market liquidity.

But that can’t be right. An ETF’s make-up does matter, and here’s why.

First, there’s a cost involved in sourcing the assets that go into the substitute basket. It’s more expensive for the issuer (or its parent bank, often the same entity) to put in AAA-rated bonds than junkier ones, for example. Even if the cost is invisible to the end-investor, it’s still there.

Where is this cost, if you can’t see it? It’s in the increased probability of: (a) something going wrong; and (b) there being a larger, rather than a smaller, loss if things do go awry.

Let’s put this another way. In the summer of 2008 there was a steady rise in the cost of insuring against the default of AIG. At the time, I pointed out that this was a hidden cost of investing in some of ETF Securities’ exchange-traded commodities, something that earned me a very unpleasant conversation with the firm’s then head of sales.

You couldn’t see that there was a cost of holding the ETCs from their tracking, which continued to be accurate until AIG did approach default. Then, of course, and without warning, the ETCs were suddenly trading at ten cents in the dollar, until the US taxpayer rescued all of AIG’s counterparties, ETC investors among them. They got lucky.

Now I know that ETFs are not the same as the formerly AIG-backed ETCs (most of ETF Securities’ commodity trackers are now collateralised, by the way). ETFs have an asset basket behind them and are funds.

But if the quality of assets in the basket of a synthetic ETF is lower than that of the index securities, you’ve simply increased the risk of loss in the future. And that risk has a cost attached to it, the cost of insurance.

The story doesn’t end there. As regulators have pointed out, the more an issuer is able to raise finance at subsidised rates via an ETF (by the provision of lower quality collateral), the more it is likely to resort to this mechanism if other sources of funding get tough. If you’re an ETF investor, incentives for your synthetic issuer to abuse the structure increase, just when you don’t want them to, in other words.

For all these reasons I’m surprised that Maier and Lanik conclude that synthetic ETF collateral mismatches are unimportant. We’re less than three years from the worst of the credit crisis, a cataclysmic event that was all about the abuse of misaligned incentives, particularly in the credit ratings system. It appears that some people have short memories.

ETF structure does matter, and people should pay attention to it.

Two Deutsche Bank strategists recently penned a report that said that exchange-traded fund issuers can easily earn twice their funds’ management fees through other, ancillary activities.

Christos Costandinides and Daniel Arnold argued that synthetic ETFs earn extra money primarily from trading (including from the provision of derivatives), while the issuers of physical ETFs gain from lending out the shares and bonds owned by the investors in their funds.

The authors didn’t go into detail. Generally speaking, though, the sources of extra revenue are hardly a secret.

It’s been well publicised that synthetic ETF providers have an economic incentive to put lower-quality assets or collateral into their funds. If they had to set aside the actual shares or bonds in the index being tracked by their ETFs, rather than what they put into these funds in practice, they’d have to pay more to do so.

“The concept of stuffing ETFs with any old clag collateral is a tried and tested revenue scheme,” one retired banker and former derivatives specialist put it bluntly.

In funds that use physical replication, securities lending revenues, of which issuers often take a healthy cut, can be substantial.

Many commentators, IndexUniverse included, pointed out that BlackRock was willing to pay more than double for Barclays Global Investors in 2009, securities lending and other operations thrown in, than what another party initially offered for iShares, the firm’s ETF management unit, alone. The differences in the values of the respective potential revenue streams were made clear.

In the Deutsche Bank report, Costandinides and Arnold argued that an increased level of transparency by issuers would address many of the potential concerns of investors and help the ETF industry to continue to grow. It’s hard to argue with that.

But there’s still a long way to go. We’re far from uniform disclosure of synthetic ETFs’ assets/collateral. Only three European issuers out of more than a dozen that use this fund structure give a daily snapshot of what their funds really hold.

And when it comes to securities lending, things are arguably even more opaque.

In a letter sent in May by Karrie McMillan, the general counsel of the US Investment Company Institute (ICI, a trade body for US fund managers), to the secretariat of the Financial Stability Board, in response to the FSB’s April note on ETFs, there’s an interesting section, right at the end, devoted to the subject of share lending.

The ICI’s main argument, as expressed in McMillan’s letter, is that the large majority of ETFs worldwide do not share the characteristics of the (European) synthetic ETF structure, and that global regulators should therefore exercise caution in making broad statements about potential ETF-related risk.

When it comes to securities lending (also highlighted by the FSB as a concern, given possible conflicts of interest) McMillan said that the Investment Company Act of 1940 (the law regulating most US ETFs) “generally prohibits a fund from lending its securities to an affiliated person or using an affiliate as a securities lending agent. The SEC has granted individual exemptions to this prohibition, subject to a number of conditions designed to ensure that the affiliated person does not take advantage of its relationship with the fund”.

“It is important to note,” McMillan continued, “that all profits from securities lending (i.e., revenues less fees paid to a lending agent or other involved parties, as approved by the fund board) accrue to the fund itself, not the adviser. While an adviser may receive fees if it is acting as the lending agent, those fees must be fair and reasonable, as determined by the fund’s board of directors.”

This sounds reassuring. But if you dig a little deeper you’ll find that different exchange-traded fund boards vary widely in their definitions of what “fair and reasonable” means, while the same fund company might even apply different rules in different jurisdictions.

BlackRock, for example (as one of the “affiliated” lending agents that has obtained an SEC exemption) keeps 40 percent of its ETFs’ lending revenues, down from a 50 percent cut that applied prior to November 2010.

But according to an article published last year in Portfolio.com, State Street, the world’s second largest ETF issuer, only retains 15 percent of its US ETFs’ lending revenues, while Vanguard apparently returns nearly all securities lending revenues, after costs, to investors.

And while State Street takes a 15 percent cut of its ETFs’ revenues from lending stocks in the US, the firm charges its ETF investors over three times more in Europe for doing the same thing—50 percent. Why the difference?

Unfortunately, having a majority of independent fund board directors doesn’t guarantee that things can’t go wrong. The legal provisions in the US fund rules that enshrine this requirement didn’t prevent the mutual fund timing scandal of 2003, one commentator on fund governance has pointed out.

Meanwhile, in Europe there’s a very wide variety of fund structures, with no regulatory requirement at all to have independents at board level, said Douglas Ferrans, our interviewee last week and chairman of the UK’s equivalent to the ICI, the Investment Management Association. There are clear governance weaknesses in some European fund jurisdictions, the IMA believes.

Given the scale of earnings that can be made over and above ETF management fees, it’s clear that there are plenty of reasons for fund boards to be looking closely at issuers’ practices when it comes to share lending, charges for derivatives and the security and quality of collateral provisions.

And some standardisation of exchange-traded fund practices in these “ancillary” fee-earning areas seems long overdue. If the ETF industry can’t come up with its own rules, it looks increasingly likely that regulators will impose some.

I was alerted to a recent Reuters survey on synthetic ETFs through a posting on the Securities Lending Traders Network group on LinkedIn. Someone posted up the story and there were several follow-on comments that I felt compelled to respond to. Rather than do that for just the group members, I thought I would share it in a blog as well.

The Reuters survey typifies the range of comments that are being thrown into the debate on ETFs. The June 14 headline was “Advisors warn against synthetic ETFs—Reuters poll”, with the subtitle describing British financial advisors as boycotting swap-based ETFs.

The first comment in the article doesn’t differentiate between swap-backed and replicating ETFs; it simply says that ETFs are geared to “burn and churn” traders. Best he sticks to equities then, where high frequency/algorithmic traders only account for between 40-55 percent of turnover on many markets.

The meteoric growth of ETFs also throws into question who exactly is boycotting ETFs and makes me wonder who was polled.

The rest of the article adds nicely to the misinformation/disinformation/confusion surrounding the subject matter. A good example of this is:

“Advisors say buyers must beware they could be buying ETF shares from a short-seller, meaning they may not have a claim on the underlying assets they want to be tracking but a promise to deliver the ETF share when the short-seller covers its position.”

I’ve read that sentence at least eight times and I’m still not certain what it says. To be clear, if you buy an ETF and it settles, then you own it and that represents your interest in the fund. It makes no difference whether you have purchased the ETF from a short-seller or a “long” seller and you have no further involvement with the short-seller covering his/her position (or not as the case may be). If it is talking about failed trades, that’s a different issue and you can read an interesting story by Paul Amery recently here.

I have been doing a lot of work on the structural risks of ETFs and want to take a moment to address counterparty risk and collateral risk as they relate to synthetic versus replicating ETFs. The reality is that the majority of ETFs carry risk in both areas, the only difference being the degree of transparency and whether the risks are incurred at the “front-end” or “back-end”. As a general comment, both types have substantial risk mitigants, so these exposures are well monitored and controlled and are in line with the trillions of dollars in the wider securities lending and total return swaps markets.

I haven’t been as aggressively outspoken on increased collateral transparency as others. My reasoning is that anyone outside of the professional marketplace doesn’t have the knowledge or experience to assess this type of market risk appropriately. The majority of institutional and retail investors aren’t in a position to understand the relevant risks. That’s not me being arrogant (although many will no doubt think that)—it’s just a fact. I’ve been through several defaults across my three decades in the business and have been involved in liquidation processes. Collateral is only worth the value you can recover in a default—ratings are less valuable than liquidity and collateral correlation is better as a theory than it is as a practice.

An example where the debate becomes misinformed is the furore over mismatched collateral. Many point to synthetic ETFs that might track an index yet hold collateral that has no correlation to that index. Instead it relies on over-collateralisation and the credit strength of the swap provider for protection. Guess what—it is commonplace in securities lending transactions that the collateral does not bear direct correlation to the assets on loan. Securities lenders rely on over-collateralisation and the credit strength of the borrower—sound familiar? Securities lending proved the resilience of its risk mitigants through the Lehman default.

The chart below summarises some of the key counterparty and market risk issues.

There are indeed differences between synthetic and replicating ETFs. Synthetics, less common and generally less understood, are at least more transparent as to counterparty exposure and collateral holdings. Neither is necessarily inherently risky and the scale of the ETF activity is a small subset of the larger businesses they are a part of.

The bottom line is that risks exist in all investments generally. Investors need to understand the risks in each investment and structure. I can’t comment here about any specific structure and each individual provider has its own products, structures, disclosure levels and practices. As a consultant of course I do risk assessment work on the topic.

I agree there is a risk that investors could be getting something different from what they are buying, and as some ETFs diverge significantly from plain vanilla funds that risk increases. But the lack of clarity and confusion doesn’t reduce the risk; it takes people down side alleys instead.

PS The Wall Street Journal printed a very good article on ETFs and securities lending last Wednesday. I agree with almost everything in the story.