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The Vanishing Illusion of Insolvency Remote ETFs

The Vanishing Illusion of Insolvency Remote ETFs

by Peter Dawe LLB (Hons) (London)


Commodity Exchange Traded Funds are often described as "insolvency remote" or "bankruptcy remote". This is intended to give Investors a sense of comfort and indeed it does offer some protection to them.

However the protection is not as great as most Investors believe, and in this short paper I will go into the limitations of that claim.

"Insolvency remote" is a phrase that is employed to describe the situation in which a company or other entity (such as a Trust) is not vulnerable to the insolvency of a holding company or any other company surrounding the insolvency remote entity.

Insolvency remoteness is achieved by building walls to protect the insolvency remote company from insolvency around it. It will therefore often have a different shareholding, control mechanism and management, to reduce its risk of contamination from the insolvency of others.

Often what goes hand-in-hand with insolvency remoteness is the use of a "special purpose vehicle" (“SPV”) which has strict limitations on activities it can engage in, with a view to making it as unlikely as possible that it will itself risk insolvency through its own activities.

Most commodity Exchange Traded Funds (“ETFs”) are SPVs. The Investor is suitably protected against the insolvency of companies which are involved in the SPV as Sponsors, Trustees and the like. The SPV can engage only in a carefully described range of activities, can incur only specified liabilities and invest in specified assets. Its costs are controlled and are payable from either its income (if it has any) or by selling some of its assets.

So far so good from the Investor point of view.

However unfortunately that is not the end of the story, and neither does this insolvency remoteness protect the Investor against some serious risks.

Let us begin by considering what fundamental rights the Investor obtains when he buys into an insolvency remote ETF.  I will use the example of SPDR GLD, the largest gold ETF in the world, which is an SPV in the form of a Trust.  However it is typical in most respects of all the commodity ETFs, and so the comments apply pretty much to all of them.

In SPDR GLD the Investor acquires shares, which the 2012 Prospectus describes as representing “units of fractional undivided beneficial interest in and ownership of the Trust”.

What does this actually mean to the Investor? Reduced to basics, it means that he acquires an undivided share in the assets of the Trust.  That means that if he has 100 shares, out of the 424 million shares issued, he "owns" 100/424 000 000 of the gold held by SPDR GLD.  Note that the Investor cannot point to a particular gold bar as being his. He has an undivided share in each gold bar that the Trust owns.

The result is that if the Trust were to default in its obligations to the Investor, he is simply a concurrent creditor of the Trust.

But a little more delving reveals that, like a babushka doll, there is another doll inside. The ETF SPV does not store its own gold. The gold is held by a Custodian. In the case of SPDR GLD the gold is in an unallocated account during the day, and an allocated account at night.  The difference between the two is that in an unallocated account the Trust simply has a concurrent claim against the Custodian. In an allocated account, the Trust is entitled to say that specific gold belongs specifically to the Trust and so its claim is to that extent secured.

The problem of course is that if the Custodian were to go insolvent during the day (more likely than for it to go insolvent at night), the Trust is simply an unsecured concurrent creditor of the Custodian.

Inside this babushka doll is another one.  The Custodian is entitled to appoint sub-custodians. The appointment of sub-custodians in the case of SPDR GLD is not in writing, but is governed by the London Bullion Market Association’s Rules and the "customs and practices of the London bullion market”.  This feature is not peculiar to SPDR GLD - it applies to most commodity ETFs. 

So what rights does the Investor really have to "his" gold?

He has a concurrent claim against the ETF. The ETF has a concurrent claim against the Custodian. The Custodian has a concurrent claim against its sub-custodian.  Only if the sub-custodian pays in full (unlikely on insolvency), and the Custodian pays in full (unlikely on insolvency) and the ETF pays in full (unlikely on insolvency) will the Investor receive the full value of his shares.

So unfortunately the "insolvency remote" blanket turns out not to be much of a comfort blanket at all. 

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