Simon Klein (pictured) and Nizam Hamid of Lyxor ETFs respond to the Financial Stability Board’s note: "Potential financial stability issues arising from recent trends in Exchange traded Funds (ETFs)"…
Klein says: "The FSB’s attention to the market is actually a sign of the success and growth that has been experienced and is to be expected in coming years. ETFs are successful because they allow all sorts of investors to be exposed to many different markets, in a very cheap and transparent way.
"ETFs have been successful in these new areas of the market and non-equity asset class exposures as they serve investors by increasing capital market efficiency which is a benefit for all clients
"From a regulatory standpoint, European ETFs fall under the requirements of the UCITS Directive. They benefit from all the UCITS regulations concerning among others the use of derivatives, the use of leverage, counterparty risks, conflicts of interests and fiduciary duties of the asset manager. With respect to synergies created within banking groups it is clear to us that these synergies operate to the benefit of the ETF holder and allow for efficiencies and enhancements to be passed through to the end client in a transparent way through the total return of the ETF versus the index
"ETF pricing accurately reflects the underlying market both due to efficient liquidity provision by market makers and trading participants and the strength of the listing environment across European exchanges and trading platforms
"Lyxor ETFs have always been open and transparent about the collateral composition, and the fact that these are assets held by the ETF. The quality of the assets in the ETF is also covered by the fact that the majority of our funds are PEA eligible, and these are required to hold at least 75% of assets in European equities. Lyxor has always made available on client request the full basket of the fund’s assets. Since the middle of March, 2011, we have been displaying the month-end fund holdings on our French website and we are in the process of rolling this out to other countries."
Hamid adds: "Lyxor ETFs has been a pioneer of the swap-based ETF in Europe since 2001, with an ETF product that complies with the UCITS requirements and approved by regulators. We would argue that the main areas of complexity and opacity relate to instruments often confused with ETFs (ETNs, ETCs and ETVs).
"ETFs are simple products with simple operations and where, in the case of synthetic exposures, the derivative content is restricted to a simple index swap. Derivatives regulations are very well detailed and well established in the context of the UCITS Directive. There is no such level of EU regulations concerning securities lending by UCITS, and the proceeds from securities lending are often paid to the manager or the custodian rather than to the fund.
"In an extreme situation of market stress, we would emphasise a number of important factors with respect to our ETFs. Firstly the key is the liquidity of the underlying markets which includes not just the cash securities markets but also associated futures markets. In a worst case scenario investors in Lyxor ETFs have access to liquid and high quality of assets held by the fund. This is an important point of differentiation that we should emphasise – we typically have a significant proportion of liquid European equities (a minimum of 75% for PEA funds).
"In aggregate the Lyxor ETFs with equity and commodity exposure have 87% of their assets in European equities whilst Fixed income ETFs have 93.6% in European bond holdings. In a situation of market stress this level of liquid collateral would mean liquidity in the fund assets would be retained even if the exposures related to different strategies were impacted. It should also be noted that the physically owned assets of the ETF are segregated from the bank’s assets.
"The focus on the OTC swaps used within ETFs is perhaps an unfair reflection of the size of the market and indeed overly dramatic. At the end of June 2010, according to the Bank for International Settlements, total forwards and swaps in equity linked derivatives was USD1,754bn. The total size of assets under management in swap-based ETFs in Europe was only USD124bn. Naturally there is a mix of swap-based models in Europe (and with Lyxor ETFs the swap exposure is limited to a maximum of 10% of the funds AUM). But even if one were to assume the full USD124bn figure, this would represent 7% of OTC swap-exposure. All equity-linked exposures at the end of June 2010 totaled USD6.3trn so again as a proportion of this European ETF swap exposure would be less than 2% of the total. Therefore we would argue that European ETF swap exposure cannot easily be presented as a source of contagion and systemic risk when compared to the broader swap and OTC market.
"ETFs in Europe fall under the requirements of the UCITS Directive and UCITS regulations do not prohibit them from entering into derivatives or shares lending to counterparties that belong to the same group. These regulations will be very much enhanced by the UCITS 4 level 2 Directive that comes into force on 1 July 2011."