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I am looking at different Exchange Traded Commodities (ETCs). I noticed that some ETCs have a collateral level of 50% and other may have 100%.

What does this collateral number mean? Is it how well the ETC will track the underlying commodity spot price, i.e. does the higher the collateral level track the commodity spot price more closely, since there is less non-invested cash in the ETC? Or does it mean something else?

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    I assume that you are referring to an Exchange Traded Commodity investopedia.com/terms/e/exchangetraded-commodity-etc.asp from context, but better practice in a question at any StackExchange is to spell out any acronym at least once in a question because almost all possible two to four letter acronyms stand for multiple things.
    – ohwilleke
    Feb 24, 2021 at 17:47

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Like exchange-traded funds (ETFs), [Exchange Traded Commodities] ETCs shares are listed and traded on exchanges like shares of stock, with prices fluctuating based on price changes of the ETC's underlying commodities. Unlike ETFs, ETCs are structured as notes, which are debt instruments underwritten by a bank for the issuer of the ETC, but which are backed by the commodities they track as collateral. Thus, ETCs should not be confused with commodity ETFs, which invest directly in and hold physical commodities, such as agricultural goods, natural resources, and precious metals . . . ETCs differ from ETFs as they are debt instruments (notes) and the commodities tracked by the ETC serve as collateral for the note.

The price of an ETC rises and falls along with its underlying commodities and, like other investment funds, ETCs charge management fees. . . .

The performance of an ETC is connected to one of two sources. It might be based on the spot commodity price (the price for immediate delivery) or based on the futures price (a derivative contract for delivery at a future date). ETCs typically attempt to track the daily performance of the underlying commodity, but not necessarily long-term performance. . . .

The way ETCs are structured varies depending on the company issuing the product. Certain exchanges, such as the London Stock Exchange and Australian Securities Exchange, offer products called ETCs that have a specific structure.

From here.

Not All ETCs Are The Structured In The Same Way

More information is needed to provide a definitive answer to your question, because different regions and different companies structure ETCs in different ways. They are not strictly analogous to an Exchange Traded Fund. Instead of having a backed of underlying assets packaged in a holding entity or trust, they are a derivative backed by collateral. Since they are structured in different ways in different places, whether or not an ETC with more collateral tracks an underlying commodity or basket of commodities more closely isn't possible to know without more information.

Default Risk

Another point is more general, however.

One of the issues with an ETC with low levels of collateral is similar to dealing with a non-insured money market fund, which tries to track the performance of an insured bank deposit account while producing a higher rate of return, by making short term loans to very creditworthy big businesses.

While it targets a particular price linked to commodity prices that is sound in ordinary market conditions, in a financial crisis or panic of some sort the ETC sponsor might default on its debt instrument obligation. If it did default, it might be uncollectible since the debt is not fully backed by collateral and the ETC is issued by a shell company with no other significant assets.

This could happen, for example, in the brief period of time when oil prices were trading at a negative value per barrel in the U.S.

This could also happen, for example, in a case analogous to the Gamestop stock situation where a group of online social media participants caused a massive shift in the security's price for reasons unrelated to economic fundamentals and unexpected by others in the market for that commodity,

It isn't easy to evaluate this risk, because it is quite low, and typically occurs in a "black swan event" which was a known theoretical possibility but had never actually happened before until it happens in many commodities at once in an unprecedentedly severe way.

In the same vein, prior to the Financial Crisis of 2008, no investor owned investment bank had ever failed (in part, because until a decade or two earlier, there were no investor owned investment banks and they were organized as general partnerships of the investment bankers instead which also created an incentive to invest more cautiously because downside risk was entirely borne by the investment bankers setting up the deals). But two years later, every single investor owned investment bank in the United States had gone bankrupt, or otherwise had all of its assets sold after becoming insolvent wiping out all of its investor owners.

ETCs are a relatively new product, and if there is a default, it is likely to happen all at once in an extreme event that affects many ETCs with less than 100% collateral, leaving a great many investors who didn't really recognize the risk burned. But it is also quite plausible that this will never happen at all.

Fun Fact

While it is rarely mentioned, licensed brokers and ETFs are generally insured against the risk that securities that they tell investors that they own outright are actually fake, but are either just taking your money without buying the securities that they claim to be purchasing or are defrauded themselves in a similar fashion (although this is not true in the case of private equity and hedge funds).

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    Thank you for your answer! I am looking at this ETC among others: wisdomtree.eu/en-gb/-/media/eu-media-files/key-documents/…
    – Clone
    Feb 24, 2021 at 20:30
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    Who is the "ETC sponsor" you mention in your reply? Is that the investor that bought the ETC "shares", the bank that has the safe securities or something else?
    – Clone
    Feb 24, 2021 at 20:32
  • @Clone It is the company that set up and probably operates the ETC.
    – ohwilleke
    Feb 24, 2021 at 22:08

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