Digital Nugget: How does the ETP structure protect investors?
Many regulators and traditional custodians in leading jurisdictions for mutual funds are still in the process of adopting digital assets in general and crypto currencies in particular. Meanwhile, somewhat more flexible structures have gained in popularity to provide investors with a liquid and cost-efficient access to this new asset class – so called Exchange Traded Products.
The term “Exchange Traded Products” sometimes refers to different wrappers, as there are a number of product structures used to provide passive exposure to underlying assets – Exchange Traded Funds (ETFs), Exchange Traded Notes (ETNs), Certificates (ETCs).
In Switzerland, the Exchange Traded Product (ETP) structure has certain characteristics that are slightly different from similar structures such as ETFs or ETNs.
The ETP structure
Generally, the term “ETP” (Exchange Traded Product) is used as a collective term, and ETFs, ETNs, ETCs are considered various types of ETPs.
However, in Switzerland ETPs are specifically defined as collateralised, non interest bearing, bearer debentures (debt securities).
• they track the performance of an underlying instrument, basket, or index.
• they may track the performance one-forone, they may be leveraged, or may track the reverse of the performance (mimicking shorting the underlying instrument).
• and they are open ended, ie. they are issued and redeemed according to demand.
As ETPs provide exposure to the underlying asset(s), they carry exactly the same market
risk as the underlying asset(s). Because they are open ended, they trade around the price of the underlying asset(s), with no risk of valuation discounts or premia (other than the bid/ask spread the market maker charges).
The credit risk on ETPs in the case of default or insolvency by the product issuer is mitigated by multiple layers of protection:
• the corresponding amount of the underlying tokens is held in secure custody at reputable third party custodians;
• the ETP is a senior claim to any other obligations of the issuer;
• when multiple ETPs are issued by the same issuer, the collateral is segregated (there is no spillover risk);
• a trustee (collateral agent) acts on behalf of the ETP holders in the case of default: the trustee liquidates the collateral and reimburses the ETP holders.
There is some residual risk in that the trustee’s costs need to be covered, and it may take time for the trustee to liquidate the collateral during which time the market price of the tokens will vary.
There is also credit risk on the custodians. The custodians typically have insurance to cover any loss of assets up to a certain amount.
Coinbase, the main custodian currently used by ETP issuer 21Shares, has insurance cover up to $255m loss per incident and per annum. Coinbase Custody has never had any incident where client funds were lost.
Product integrity is ensured by multiple independent parties overseeing various parts of the process by which the Net Asset Value of the ETP is arrived at.
These parties are:
• the administrator,
• the data provider(s),
• the index calculation agent,
• the index owner.
These parties are all independent of each other, and are regulated with regard to the tasks they perform.
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