The G20’s Financial Stability Board (FSB), the international body tasked with monitoring the stability of the global financial system, has called for regulators to pay increased attention to the exchange-traded fund market. In a note released today the FSB calls a number of recent ETF market developments “disquieting”.
Specifically, the FSB says that the increased popularity of “synthetic” ETFs (which use derivatives to track the underlying index) and the more intensive recourse to securities lending by providers of traditional ETFs should raise concerns over possible counterparty and collateral risks.
In addition, according to the FSB, the fact that ETFs promise on-demand liquidity could cause financial instability at a broader level. The intraday tradeability offered by ETFs may create acute redemption pressures in certain types of funds during situations of market stress, says the board, which could in turn affect the liquidity of the large asset managers and banks active in this market. This is particularly true, says the FSB, where ETFs have branched out to asset classes such as fixed income, credit, emerging markets and commodities, where liquidity is typically thinner and transparency lower than in developed equity markets.
The outspoken comments from the body coordinating international regulatory policy follow similar interventions from a number of national financial market supervisors.
Early last year the US Securities and Exchange Commission said it was reviewing the use of derivatives by investment companies, including ETFs, and deciding whether more protection is warranted for investors. The review is ongoing and approvals of new ETFs using derivatives have since been halted. In January 2011, the UK’s Financial Services Authority warned investors about the risks inherent in leveraged exchange-traded products. Hong Kong’s Securities and Futures Commission followed suit in February with new naming rules for synthetic ETFs. In March the Reserve Bank of Australia drew attention to risks inherent in ETFs in its quarterly bulletin.
Specific concerns highlighted by the FSB in its new policy note include possible conflicts of interest inherent in the way ETFs are structured and traded. One potential conflict may arise from the dual role of some banks as both issuer and derivative counterparty in synthetic ETFs, says the FSB. “The synthetic 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’s note’s asserts.
“In case of unexpected liquidity demand from ETF investors,” the FSB continues, “the provider might face difficulties liquidating the collateral and may be faced with the difficult choice of either suspending redemptions or maintaining them and facing a liquidity shortfall at the bank level. 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.”
Monitoring collateral quality is therefore a crucial consideration for investors in synthetic ETFs, concludes the FSB, and this in turn depends on the level of transparency provided by the issuer into its collateral arrangements. Last year Credit Suisse, iShares and Deutsche Bank all started publishing the daily composition of ETF collateral used to back their swap-based funds, though other European providers have yet to follow suit.