Understanding currency ETCs
I was confused yesterday about currency ETCs; after a detailed conversation with Nik Bienkowski of ETF Securities, I think I understand them a bit better.
The answer to my central question about whether you can try to play the carry trade with these things is quite clear: it’s yes. The mechanism is just as commenter Daniel described it: the funds essentially buy currency forwards expiring tomorrow, sell them just before expiry, and roll over into a new short-dated forward. These forwards are extremely liquid, and since that constant rolling one-day exposure in the forwards market does an excellent job of reflecting the differences in local interest rates.
As a result, says Bienkowski, if the Aussie dollar ETC had existed for the past five years, holding it would have returned 4.8% per annum, before fees, over and above whatever you would have got from holding Aussie dollars alone. Fees are 39bp per year, accrued daily, so you genuinely can get a bit of carry out of these things.
So what’s all this about T-bill interest rates? It all comes down to the nature of the derivatives market. If I’m buying a forward expiring tomorrow and then selling it just before it expires, I don’t actually pay cash for the forward in one transaction and receive cash in a separate transaction when I sell it. Instead, the transaction gets netted out. If the currency has moved in my favor, I get paid a small amount of money; if it has moved against me, I pay a small amount of money. If it hasn’t moved at all, I get a tiny amount of money, corresponding to one day’s interest in local currency. Annualize that tiny amount of money, and you’re looking at the carry.
The investors, meanwhile, have put up an amount of money corresponding to the full notional amount of the underlying currency. That money needs to be invested somewhere, so it gets invested in T-bills. Hence the added T-bill interest rate. The T-bill interest rate isn’t large, but it’s the only actual interest paid on these instruments. The local-currency interest, by contrast, is basically an arbitrage condition: the forwards markets always reflect local interest rates because if they didn’t there would be a no-brainer arbitrage there. (This kind of arbitrage can fall apart during something as chaotic as the Icelandic devaluation, which was accompanied by the default of all the local Icelandic banks, but the currency ETCs invest only in G10 currencies, where that kind of thing hasn’t ever happened. Yet.)
The ETCs are dollar-denominated, and they all include either a long-dollar or a short-dollar position. The two facts cancel each other out, so if you’re a UK or euro investor who buys say the long Aussie-dollar ETC, you’re essentially getting direct exposure to the Aussie dollar in pounds or euros or whatever the currency is that you’re using to buy and sell the ETCs.
The ETCs are guaranteed to underperform their index, thanks to those 39bp in fees. But they shouldn’t underperform more than that, since Morgan Stanley has promised to pay the index return. “If Morgan Stanley didn’t pay us the index, they would be in default,” says Bienkowski. On top of that, much of the added complexity of the instruments is essentially designed to hedge precisely that Morgan Stanley counterparty risk.
Bienkowski is a fan of the instruments. “If you want to get access to foreign currency, I think these products are pretty good,” he says. “They aren’t leveraged, they’re not a CFD or a warrant. They’re basically bringing institutional money-market interest rates and spreads to the average investor. “
Thatsaid, currency ETCs are complex, and not easy to understand. There’s language in the prospectus about not buying them without talking to an independent financial advisor, but the fact is that most independent financial advisors aren’t going to be able to understand this prospectus very easily either. (Izabella Kaminska and I are at least as good at understanding these things as most independent financial advisors are, and we got very confused by them.)
If you’re a fan of the UK Financial Services Authority, you might take some solace in the fact that it has signed off on these currency ETCs; they fulfill its listing requirements as debt securities. “We’re bringing the wholesale currency market to a regulated exchange,” says Bienkowski. But the fact is that there’s still a lot of complexity here. In general it’s a good idea not to buy things you don’t understand, and there’s a lot of stuff in the prospectus which is difficult to understand.
On the other hand, historically it has been almost impossible for retail investors to play the carry trade, invest in foreign exchange, or in general diversify into fx as an asset class. If you’re worried that your investment currency is going to implode (be it dollars or pounds or anything else), then buying a few of these ETCs will give you some kind of hedge against that, helping to preserve international purchasing power. The underlying mechanics of them are not particularly pretty, but if you’re going to rely on the continued liquidity of any financial market in the world, the fx market is probably the best one to rely on: it’s incredibly liquid and robust.
Currency ETCs are very new and untested things, and so a sensible investor will probably hold off for a little while longer to see how they do. It might also be interesting to see whether and when a similar product might list on a US exchange. But in principle I can see why these things were invented, and I can also see why a certain class of globally-focused retail investor might be interested in buying them.