The Financial Stability Board (FSB) has expressing concerns over the growth of ‘synthetic’ ETFs and the use of securities lending by providers of ‘plain vanilla’ ETFs in its latest note on ‘Potential financial stability issues arising from recent trends in exchange-traded funds (ETFs).
The FSB’s note states, “There are a number of disquieting developments in some market segments which call for closer scrutiny. ETFs have branched out to other asset classes (fixed-income, credit, emerging markets, commodities) where liquidity is typically thinner and transparency lower.”
“The increased popularity of “synthetic” ETFs (which use derivatives) as well as the more intensive recourse to securities lending by ETF providers of plain-vanilla ETFs raises new challenges in terms of counterparty and collateral risks. In addition, 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.”
The key points in the FSB’s note are summarised below for the benefit of etfexpress readers:
Increase in complexity and opacity; Synthetic ETFs:
Among recent innovations, a specific trend warranting closer scrutiny is the recent acceleration in the growth of synthetic ETFs on some European and Asian markets. In this type of ETF, 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.
Since the swap counterparty is typically the bank also acting as ETF provider, investors may be exposed if the bank defaults6. Therefore, problems at those banks that are most active in swap-based ETFs may constitute a powerful source of contagion and systemic risk.
In addition, the incentives behind the creation of synthetic ETFs may not be aligned along the ETF chain, especially as conflicts of interest can arise from the dual role of some banks as ETF provider and derivative counterparty. As there is no requirement for the collateral composition to match the assets of the tracked index8, 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.
In case of unexpected liquidity demand from ETF investors, 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.
More broadly, investors in synthetic ETFs need to exercise an adequate level of scrutiny and due diligence on collateral selection and arrangements, which in turn depends on the level of transparency made available by ETF providers. Important considerations relate to the rules for selecting the collateral, the screening of its credit quality and its liquidity, valuation practices and haircut determination, and segregation of assets. The existence of regulatory or other limits regarding the derivative exposure would also help contain the risks mentioned above.
Risks for market liquidity; Incentives for securities lending:
While benefiting formally from market making arrangements, ETFs may nevertheless experience liquidity disruptions. In principle, ETFs offer on-demand liquidity to investors while they are in some cases based on much less liquid underlying assets. Therefore, in the event of a market sell-off or an unwind in any particular ETF, there is a risk that investors massively demand redemption.
Depending on the specific ETF arrangements, redemptions could be made “in-kind” which would alleviate liquidity pressures. However, 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. Further study would also be useful for assessing the potential impact of heavy ETF trading on the liquidity and the price dynamics of the referenced securities, particularly if they do not have an active secondary market (e.g. emerging market ETFs).
In the same vein, thin margins on plain-vanilla physical ETFs create incentives for providers to engage in extensive securities lending in order to boost returns. Some ETF providers are said to generate more fee income from securities lending than from their traditional management fees.
Since securities lending is a bilateral collateralised operation, it may create similar counterparty and collateral risks to synthetic ETFs. In addition, it could make the liquidity position of the ETF fragile, by challenging the ability of ETF providers to meet unexpected liquidity demands from investors, particularly if outflows from ETFs become significant under severe stress.
A prevalence of securities lending could create a risk of a market squeeze in the underlying securities if ETF providers recalled on-loan securities on a large scale in order to meet redemptions. In addition, 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. In this regard, it is worth noting that some jurisdictions impose reporting and disclosure requirements (e.g. on-exchange registration) on securities lending that would contribute to lower risks.
Risk implications for authorities, ETF investors and providers:
The very strong growth of collateralised structured operations in the context of synthetic ETFs and ETF-based securities lending suggests that there are significant benefits for authorities and ETF market participants alike in improving their understanding of the risks attached, and the ways in which they can be mitigated.
The current protracted period of low interest rates provides incentives for re-leveraging in non-standard market segments, which may lead to a build-up of financial vulnerabilities, especially as the process of financial repair is not complete. Potential destabilising interactions with other financial innovations (e.g., high frequency trading) that could amplify negative effects also require attention.
Market and banking supervisors and regulators are in the process of stepping up their monitoring of the ETF market. Work is underway nationally and internationally on assessing how recent innovations in this area can add to financial system risks, what incentives underpin them, and what potential flaws there might be in current risk practices.
The interaction of ETF regulatory frameworks with recent innovations as well as the scope for regulatory arbitrage across regions and markets is also being examined. Imposing higher disclosure and reporting requirements as well as regulatory and other limits could help to alleviate the risks emerging in complex instruments, and prevent the emergence of conflicts of interest.
The FSB’s note concludes, “In view of the new challenges raised by recent trends on ETF markets, ETF providers and investors should review the risk management strategies of ETFs, especially in areas such as counterparty risk and collateral management, as well as assessing their exposure to market and funding liquidity risks. Furthermore, ETF providers should consider enhancing the level of transparency they offer to investors on the entire range of ETF products, especially the more complex ones. In particular, they should make publicly available detailed frequent information about product composition and risk characteristics, including on collateral baskets and arrangements for synthetic ETFs and securities lending, to enable investors to exercise their due diligence and promote a better understanding of the ETF market at large.”
The FSB welcomes feedback on this note. Feedback should be submitted by 16 May 2011 by e-mail (firstname.lastname@example.org) or post (Secretariat of the Financial Stability Board, c/o Bank for International Settlements, CH-4002, Basel, Switzerland).