What is Counterparty Risk?
In our opinion, counterparty risk is the biggest risk to inverse ETFs. The way most inverse ETFs actually achieve the inverse return is though the use of derivatives contracts with another entity (the ‘counterparty’) which is often a financial institution. The counterparty will agree (through the derivative contract or agreement, often a “swap”) to pay the inverse ETF the opposite value of some referenced benchmark.
Remember, the way inverse ETFs aim to track a benchmark is with some type or combination of a derivatives position (often swaps, but also options and futures, etc). In theory, if those derivative contracts become strained, the ability for the fund to deliver the promised return or receive the posted collateral from the counterparty to achieve the stated target of the inverse ETF could be compromised. These risks are spelled out in any inverse ETF prospectus.
Further, some benchmarks have been created by the fund’s issuers themselves, who’s trading desks are also the (only) counterparty. These could become problematic to the holder of an inverse ETF if the issuer/counterparty gets into financial distress.
As mentioned, the counterparties are often financial institutions, namely large banks like Bank of America, Goldman Sachs, Deutsche Bank and Societe Generale. We saw how counterparty risk increases with funds that have a sole issuer who is also the sole counterparty. For example, UBS has ETRACS products and two leveraged MLP funds closed down recently. An inverse ETF holder should watch the counterparties creditworthiness over time. Ideally, you want the inverse ETF you’re using to have multiple, stable counterparties and centrally cleared derivatives.
Other Inverse ETF risks include: