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ICFR Richard Reid

Systemic Risk and ETFs – Lessons from GBP1.3bn UBS loss

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Dr Richard Reid, Head of Research at the International Centre for Financial Regulation (ICFR) comments on the lessons from the UBS trading story and why ETFs could be a source of systemic risk in the economy…

One of the potential sources of systemic risk in recent months has been the rise in importance of the Exchange Traded Funds (ETF’s). This issue has been further highlighted now by the latest revelation of a huge trading loss in a leading European investment bank, apparently associated with trades related to over-the-counter ETF activity. Although very costly for the institution itself, it does not seem to have caused any wider systemic problems. But it will raise many questions both about the systemic risks which might emanate from the growth in ETFs as well as the effectiveness of the risk control systems implemented since the onset of this financial crisis.

Back in June, in the first Financial Stability Report (FSR) – produced under the auspices of the UK’s new super-regulatory body, the Financial Policy Committee (FPC) – key areas of concern were indeed the implications of complexity and innovation arising from the growth in ETFs (see graph below). Questions of size, interconnectedness and complexity all strike at the heart of systemically important financial intermediaries (SIFIs). Just how much “sifi-ness” there is for a particular institution is of course the subject of a very active debate. The UK has not been alone in thinking about this, and indeed this FSR mentions other studies by the FSB, the BIS, and the IMF.

As the Bank of England report noted, ETFs started off around 1990 by using investors’ cash to purchase a basket of securities comprising the index from the market – the “physical” replication. These are typically simple products but may be exposed to counterparty risk. They may also have limited disclosure of lending practices. In contrast to physical ETFs, synthetic ETFs do not purchase the index securities outright, but gain exposure by entering into derivatives contracts with a counterparty (typically an affiliated bank). These synthetic ETFs are therefore much more complex and may also represent liquidity risks to bank funding. They raise memories of the subprime crisis, packaging of mortgage bonds and a basically good idea turning into a poorly understood and monitored innovation.

It is probably early enough in the growth of these funds to be able to say that they do not represent a truly systemic risk although this latest episode will be seen as a real warning signal. For some time now there have been some voices in the industry raising concerns, particularly about the number of new vehicles. Regulators, conscious of the pressure they are under to consider ways of heading off systemic risks to financial stability, will be keen to think about what steps they should be taking now to supervise this market segment. The emphasis so far, as the June report stated, has been better characterisation and disclosure needs, as well as collateral and liquidity management.  We may see a hardening in approach following this latest incident.”

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