The Financial Stability Board wrote a report in April this year saying that ETFs might present new, unexpected risks to financial stability.
The full report is available for download by clicking here.
Essentially, the report says that regulators should watch these relatively new products because they can be moulded into just about anything, and they’re hot thanks to the extended period of low interest rates, which is pushing investors to create leverage in new areas.
And because they’re dangerous.
The board found that three things about ETFs pose potential risks to financial stability:
- The provider might 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 and the bank level. The expectation of on-demand liquidity may create the conditions for acute redemption pressures on certain types of ETFs in situations of market stress, which could in turn affect the liquidity of the large asset managers and banks active in this market.
- A bank default could result in contagion. Since the swap counterparty is typically the bank also acting as ETF provider, or a group of banks acting as counterparties, investors may be exposed if the bank defaults. Therefore, problems at those banks that are most active in swap-based ETFs may constitute a powerful source of contagion and systemic risk.
- ETFs might create risks for market liquidity. In the event of a market sell-off or an unwind in any particular ETF, there is a risk that investors massively demand redemption. Were redemptions to be made in cash, this could raise issues as to the exit strategies and liquidity risk of ETF providers and swap counterparties. The use of ETFs as collateral in a long chain of secured lending and rehypothecation may create operational risks and contribute to the build up of leverage.
The FSB brings up these risks in part because the ETF market has boomed recently. The boom can in part be traced to the current period of protracted low interest rates, which provides incentives for re-leveraging in non-standard market segments.
Whatever the reason, the industry grew at an average of 40% year over year over the past 10 years, says the report. And while most of that growth has been in “plain vanilla” ETFs (like the one that tracks the S&P 500 for example), that are backed by physical assets, in Europe much of that growth has been in “synthetic” ETFs that are created by entering into an asset swap (ie an OTC derivative), with a counterparty*. They up make much more of the ETF market in Europe, reaching 45% of that market.
And ETFs are an area where innovation is booming too. ETFs have branched out to other asset classes (fixed-income, credit, emerging markets, commodities) where liquidity is typically thinner and transparency lower.
Given their recent boom, their underlying assets (or lack thereof), and the relatively little that is understood about the risks they might pose, might ETFs be the new CDOs? The FT’s Gillian Tett talked about this back in May.
The central problem is that the ETF sector – just like those “boring” CDOs five years ago – is currently in the grip of a wave of investor enthusiasm that risks turning a fundamentally sensible innovation bad… And some ETFs are now using leverage; others are starting to purchase riskier assets such as risky loans… And precisely because the market has exploded with such stunning speed, it may be changing flows in unpredictable ways.
Of course there are reasons to take all this with a grain of salt. For example: At the end of Q3 2010, the global ETF industry had $1.2 trillion in assets under management, which is tiny compared to the hedge fund industry, for example. And the new products (leveraged ETFs, inverse ETFs and leveraged-inverse ETFs) only represented 3% of the total ETF market in 2010.
But now we have two instances where “rogue traders” lost billions for their firms trading (or falsely accounting for trading) ETFs.
Of course it was allegedly made via fraudulent accounting and not any flaws inherent in the ETFs. But for products that are supposedly so transparent, some surprisingly large losses have resulted from a couple of back office employees trading them.
* The provider (typically a bank’s asset management arm) sells ETF shares to investors in exchange for cash, which is then invested in a collateral basket, the return of which is swapped by the derivatives desk of the same bank for the return of an index.
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