Indian Gold ETFs become Gold ETNs

Last week, the Securities and Exchange Board of India allowed Indian gold Exchange Traded Funds (ETFs) to deposit their gold with a bank under a Gold Deposit Scheme instead of holding the gold in physical form. In the Gold Deposit Scheme, the bank does not act as a custodian of the gold. Instead, the bank lends the gold out to jewellers (and others) and promises to repay the gold on maturity.

In my view, use of the Gold Deposit Scheme will convert the Gold ETF into an ETN (Exchange Traded Note) or an ETP (Exchange Traded Product). The ETF does not hold gold – it only holds an unsecured claim against a bank and is thus exposed to the credit risk of the bank. If the bank were to fail, the ETF would stand in the queue as an unsecured creditor of the bank. The ETF therefore does not hold gold; it holds a gold linked note.

So far, the ETFs in India have been honest-to-God ETFs instead of the synthetic ETNs and ETPs that have unfortunately become so popular in Europe and elsewhere. With the new scheme, India has also joined the bandwagon of synthetic ETNs and ETPs masquerading as ETFs.

Truth in labelling demands that any ETF that uses the Gold Deposit Scheme should immediately be rechristened as an ETN. I also think that this is a change in fundamental attribute of the ETF and should require unit holder approval.

From a systemic risk perspective, I fail to see why this concoction makes sense at all. It unnecessarily increases the inter-connectedness of the banking and mutual fund industries and aggravates systemic risk. A run on the bank could induce a run on the ETF and vice versa. All this is in addition to the maturity mismatch issues described by Kunal Pawaskar.

I can understand the desire to put idle gold to work, but that does not require the intermediation of the bank at all. The ETF can lend the gold directly against cash collateral with daily mark to market margins. Even if it were desired to use the services of a bank, there are better ways to do this than to treat the ETF just like any other retail depositor. For example, the bank could provide cash collateral to the ETF with daily mark to market margins. As is standard in such contracts, a portion of the interest that the ETF earns on the cash collateral would be rebated back to the bank to cover its hedging and custody costs.

Posted at 1:29 pm IST on Fri, 22 Feb 2013         permanent link

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