Bank Of England Urges Caution In ETF Innovation

  1. The Bank of England has issued a warning about ETF innovation in its June 2010 Financial Stability Report, released today (25 June). According to the Bank, “it is important that the industry does not overreach when innovating in the ETF arena; the industry and regulators have an interest in the integrity and resilience of the market.”

    The UK’s central bank, soon to acquire the responsibility for monitoring the financial sector’s overall stability from the Financial Services Authority, does note the potential benefits of ETFs.

    “ETFs can give a wider population of investors access to a wide range of instruments in a reasonably liquid form. Many funds are low cost, have proved highly liquid so far and have tracked closely underlying indices. The broad range of funds available can sometimes make ETFs a more attractive hedging vehicle than futures, while their lower fees may help investors to achieve passive index returns at a lower cost than through traditional asset management products,” the report’s authors write.

    They go on to point out, however, that risks to financial stability may arise as a result of ETFs’ usage and structure. In particular, they say, intraday liquidity on financial markets cannot be guaranteed to keep ETF prices in line with those of the underlying securities; excessive use of leveraged ETFs might undermine the market as a whole; securities lending exposures in ETFs lack transparency and could lead to investors facing liquidity constraints when exiting an investment; and swap-based ETFs embed some counterparty exposures in complex ways.

    It’s therefore possible, the Bank concludes, “that the benefits of ETFs become outweighed by complexity, opacity and contingent risks.”

    Regulators’ interest in exchange-traded products is on the increase worldwide. In the US, the Securities and Exchange Commission announced in March this year that it is investigating the use of derivatives within ETFs, while the preliminary joint SEC/CFTC report on the “flash crash” devotes extensive attention to the role of ETFs in the violent intraday trading swings of 6 May.

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