Last Updated: 1 February 2023
The responses given by European issuers of exchange-traded funds to last week’s spate of risk warnings from global regulators have highlighted the diversity of ETF business models in use across Europe.
iShares, Lyxor and ETF Securities have all issued official statements in response to the G20 Financial Stability Board’s paper entitled “Potential financial stability issues arising from recent trends in Exchange-Traded Funds (ETFs)”, which was released last week.
Mario Draghi, chairman of the FSB and governor of the Bank of Italy, used last weekend’s spring conference of the International Monetary Fund to add a verbal warning to the written ones, calling the ETF market boom “reminiscent of what happened in the securitisation market before the [credit] crisis”.
In its response to the FSB’s paper, iShares welcomed the regulators’ call for enhanced transparency, while accepting that a number of recent developments within the industry require closer scrutiny. iShares is Europe’s largest issuer of exchange-traded funds and uses the traditional method of physical replication in the large majority of its index trackers.
“It is encouraging that the FSB calls not just for transparency but also for providers to evidence to investors a demonstrable infrastructure to support transparency,” said Joe Linhares, the firm’s European head.
“iShares agrees with the concerns arising from potential conflicts of interest where swap-based ETFs and their derivative trading counterparts are within the same group,” continued Linhares, “and particularly notes the concern that ‘risks increase if the bank considers the synthetic structure as a stable and inexpensive source of funding for illiquid securities’.”
In its paper, the FSB had highlighted the risk of ETFs issued by the subsidiary of a bank being used as a means for the bank to obtain a stable and inexpensive source of funding for illiquid securities. In the swap-based ETF model, now used by the majority of Europe’s ETFs, a bank issues a contractual guarantee to the ETF to provide the return on the index being tracked, while providing a substitute basket of often unrelated securities to back its promise. Seen from another perspective, this structure enables a bank to obtain financing from the ETF for part of the inventory of securities held in the bank’s trading book.
“The synthetic (swap-based) ETF creation process may be driven by the possibility for the bank to raise funding against an illiquid portfolio that cannot otherwise be financed in the repo market,” the FSB warned last week.
This practice might then cause problems if unexpectedly large outflows from such ETFs occurred, the FSB pointed out.
“The ETF provider might face difficulties liquidating the collateral and may be faced with the difficult choice either of suspending redemptions or maintaining them and facing a liquidity shortfall at the bank level,” argued the authors of the FSB paper. “In short, risks increase if the bank considers the synthetic ETF structure as a stable and inexpensive source of funding for illiquid securities. ETF investors may not always have sufficient control over collateral arrangements to enable them to prevent such a situation.”
Lyxor, Europe’s second-largest issuer of ETFs and a follower of the swap-based replication model for all its funds, pointed out in its response to the FSB’s paper that European ETFs operate within a long-established legal framework. Lyxor is a subsidiary of French bank Société Générale.
“From a regulatory standpoint European ETFs fall under the requirements of the UCITS Directive. They benefit from all the UCITS regulations concerning among others the use of derivatives, the use of leverage, counterparty risks, conflicts of interests and fiduciary duties of the asset manager,” said Simon Klein, head of European exchange-traded funds at the issuer.
Addressing the FSB’s argument that ETFs may be used by a bank-owned issuer to obtain cheap financing for the parent company, Klein asserted that the combination of bank and ETF issuer within a single organisation offers synergies that ultimately benefit the ETF owner.
“With respect to synergies created within banking groups, it is clear to us that these synergies operate to the benefit of the ETF holder and allow for efficiencies and enhancements to be passed through to the end client in a transparent way through the total return of the ETF versus the index,” said Klein.