Thoughts From The LSE Conference

I attended today’s ETF conference at the London Stock Exchange, and here are some of the main topics of debate.

But, first, a quick riposte to Mr. Hougan. Well, Matt, it looks as though deflation is going to be what we get, whether we like it or not. That’s what the long bond yield and the action in the Treasury market are telling us. As the late economist Kurt Richebacher said, “The only cure for a bubble is to stop it from developing in the first place.” In other words, once you’ve got a bubble, no amount of cutting interest rates, easing bank lending requirements, running bigger government deficits, sending out rebate checks, buying up Wall Street’s foolish mistakes, or bailing out sinking businesses will help.

In the meantime, it looks as though we are well on our way to the next bank failure or failures, if the stock prices of some leading institutions are any indicator. Let’s see how the latest trauma gets handled. It may be another busy weekend for regulators and bank CEOs.

At the ETF conference this morning at the London Stock Exchange, the topics of counterparty risk, securities lending, swap exposures and pricing issues were well to the fore. I think it’s fair to say that, while participants were still pretty optimistic about the prospects for the ETF market, there was also a keen sense of lurking risks. Eleanor Hope-Bell of iShares and Manooj Mistry of db x-trackers went into considerable detail on the technical and structural aspects of their firms’ products (which are largely cash-based, or physically-replicated in the case of iShares, entirely swap-based for db x-trackers).

Both argued, convincingly, that there is a great deal of transparency in ETFs, when compared to competing products, and that the last few months’ debate over counterparty risks has markedly improved understanding of how ETFs work. Mistry pointed out that most clients, once the structures are explained, are comfortable with the risks involved, and the continuing inflow of funds into European ETFs bears this out.

At the same time, concerns remain. Chris Sutton of Watson Wyatt described securities lending as “picking up pennies in front of a steamroller, and the steamroller is gaining speed.” Anthony Hilton, the moderator, asked whether anything similar to the problems facing Lehman’s prime brokerage clients (who are facing a wait of years to get their assets back) might happen with ETFs, if securities are lent out. It’s clear that ETF issuers have tightened their lending and collateral management policies this year, but it’s also true that counterparty relationships are fiendishly complicated to disentangle in the case of institutional failure.

And pricing concerns won’t go away. The Wall Street Journal wrote on the subject yesterday, and I asked Eleanor Hope-Bell about the well-reported discounts that appeared on a number of corporate bond ETFs last month.  Were index compilers getting inaccurate price feeds from their market-making sources, or were bid-offer spreads really 9-10% on October 10th? The latter, said Hope-Bell. Pietro Poletto, Head of the ETF section at the LSE, reminded the audience that there are large parts of the securities market from which secondary price quotes have disappeared completely.

So the fact that ETFs are as liquid as their underlying holdings can be seen as a positive, but also as a warning. On the one hand ETFs compare well with very many illiquid and opaque structured products.  But this year’s equity market declines, the continuing stresses in the bond markets, and increasing capital constraints on the banks that make markets mean that we can no longer view the underlying liquidity as something to be taken for granted.

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