Hidden Credit Risk in Currency Funds

With more than a hat tip, but a full bow to my reader Eric, I present a recent comment of his:

Eric Says: Regarding your existing portfolio, you’ve sometimes held FXF and other Proshares Currency funds. Based on the following excerpt, does it seem to you that these funds are too dependent upon the solvency of JP Morgan?

“The Trust has no proprietary rights in or to any specific Swiss Francs held by the Depository and will be an unsecured creditor of the Depository with respect to the Swiss Francs held in the Deposit Accounts in the event of the insolvency of the Depository or the U.S. bank of which it is a branch. In the event the Depository or the U.S. bank of which it is a branch becomes insolvent, the Depository’s assets might not be adequate to satisfy a claim by the Trust or any Authorized Participant for the amount of Swiss Francs deposited by the Trust or the Authorized Participant, in such event, the Trust and any Authorized Participant will generally have no right in or to assets other than those of the Depository. In the case of insolvency of the Depository or JPMorgan Chase Bank, N.A., the U.S. bank of which the Depository is a branch, a liquidator may seek to freeze access to the Swiss Francs held in all accounts by the Depository, including the Deposit Accounts. The Trust and the Authorized Participants could incur expenses and delays in connection with asserting their claims. These problems would be exacerbated by the reality that the Deposit Accounts will not be held in the U.S. but instead will be held at the London branch of a U.S. national bank, where it will be subject to English insolvency law. Further, under U.S. law, in the case of the insolvency of JPMorgan Chase Bank, N.A., the claims of creditors in respect of accounts (such as the Trust’s Deposit Accounts) that are maintained with an overseas branch of JPMorgan Chase Bank, N.A. will be subordinate to claims of creditors in respect of accounts maintained with JPMorgan Chase Bank, N.A. in the U.S., greatly increasing the risk that the Trust and the Trust’s beneficiaries would suffer a loss.”

I have written about credit risk of ETNs before, but now I have to write about credit risks of ETFs. When an investment consists of foreign currency bank deposits of a single bank, there is a concentrated credit risk. In this case, the credit risk is to JP Morgan’s London branch. A default could be messy, with different laws in the UK.

This just highlights the risk involved with esoteric asset classes, where the “cheap” way of getting the exposure comes through credit or derivative agreements.  Be wary as you consider unique ETFs and ETNs; there can be credit risks that you have not considered.