“With such a visible shift of assets into passive strategies, it is inevitable that the ECB and regulators view the growth of the ETF industry with some concern,” says Federico Cupelli (pictured), senior regulatory policy adviser at EFAMA.
However, he believes that there are misconceptions around the true liquidity resilience of the ETF structure. “ETFs play a role in offering liquidity in the sense that they are easy to trade, fully transparent, cheaper than ordinary mutual funds and can on several occasions act as a proxy for the underlying market by aiding price discovery.”
Cupelli’s comments follow on from two publications. In November 2018 the ECB published findings around liquidity and counterparty risks in ETFs and in June 2019, the Advisory Scientific Committee at the European Systemic Risk Board (ESRB) published a paper, ‘Can ETFs contribute to systemic risk?’, which assessed how the growth of ETFs has changed the behaviour of investors. Both papers highlight the fact that ETFs could pose liquidity and ultimately, systemic risks.
Cupelli does not see the market impact the studies are suggesting. Among the findings, the ECB states that the wider use of ETFs may come with a growing potential to transmit and amplify risks in the financial system with potential disruptions to the liquidity of ETF shares in secondary markets.
The ESRB report discusses the channels through which ETFs can affect systemic risk, one of which, the decoupling of ETF prices from those of constituent securities at times of stress could have potentially destabilising effects on financial institutions heavily exposed to ETFs or reliant on them for liquidity management.
“The prime issue we have with the ECB point of view is that it does not sufficiently appreciate the secondary market as being a shock absorber. Their thinking is that if there is a massive sell off in ETF shares then it inevitably impacts the price of the underlying securities. But this is not true.”
He gives the example of a FTSE 100 ETF on the day after Brexit where there was significant market correction. “We can see that there was a huge pick up in secondary market activity but there was absolutely no underlying dealing in the FTSE 100 stocks; the effect of the take up in the secondary market did not translate into the real economy. This proves that there are no feedback loops and ultimately no systemic effects.”
“Despite the recurrence of such episodes, none has approached the systemic proportions as assumed throughout the ECB’s study. Moreover, as the study also admits, such episodes have been short-lived.”
Antonio Sanchez, principal economist, ESRB and co-author of the ESRB ASC report, says that while the arbitrage mechanism of ETFs can isolate underlying securities from volatility in the ETF market, “some investors use ETFs for liquidity management on a daily basis, therefore, decoupling could have a negative impact on them and lead to contagion to other parts of the financial markets.” The ESRB report found that Authorised Participants (APs), many of whom are high frequency traders and are in the market to seek profit could potentially exit the market in times of stress, therefore reducing liquidity.
“It would be unfair to say that there are no risks in ETFs because there are risks in all investments,” explains Adam Laird, Head of ETFs, Lyxor ETF, “but evidence shows that ETFs have been less impacted in times of stress than other forms of investment. The fact that they can be traded on a secondary market is an advantage.”
Hector McNeil, co-Founder & co-CEO, HANetf says that it is not that ETFs are not impacted by the underlying liquidity of the asset class they are linked to. “However, the actual structure of ETFs means that buyers and sellers can still get an accurate picture of the available liquidity in an ETF every day, unlike a mutual fund where this is yet another unknown on top of whatever issues there may be at an asset class level. Also, ETFs that track an index usually have a liquidity screen that only includes stocks that meet a minimum liquidity measure. But ETFs are not a magic wand for liquidity – if there are underlying liquidity issues in the asset class, this will be reflected in the ETF – along with every other type of investment wrapper with a similar exposure.”
Cupelli adds: “If there is higher volatility or if an underlying event like an exchange closure occurs, such as in Greece in 2015, investors holding ETF shares can still trade.
“These are telling cases and they show that exposure can be traded even though the individual components may be suspended temporarily for whatever reason. In such rare instances, the ETF temporarily functions as the best approximation of the underlying market. In this way they are liquidity enhancing by aiding price discovery.”
Cupelli also highlights the fact that ETFs are first and foremost, funds. He reiterates that they are highly regulated, especially in the EU under the UCITS framework, and have several features in common with ordinary mutual funds. “The key additional attribute is the added liquidity which is provided by the secondary market.
“They come under the full UCITS regime as well as a host of other regulations such as MiFID II and EMIR which is particularly important when looking at collateralising ETF exposures with external counterparties. They also report under the Securities Financing Transaction Regulations (SFTR) that gives both investors and regulators a lot of information as to the type of collateral and who the service providers to the ETFs at each moment are. Together this information already sufficiently informs investors and regulators alike, so the opacity some supervisors are concerned about is simply not there.”
Commenting on the report generally, Laird says: “These reports ask important questions. Investors need to be aware of the risks whenever they are buying ETFs. There can be risks with liquidity; if you are forced to sell then you might not get the best price, but we have evidence on our side that the ETF structure has held up.”
While Cupelli disagrees with some of the arguments put forward he sees the ECB/ESRB reports as another positive opportunity for the industry to address some of the common misconceptions. “With the ETF industry now at USD5.5 trillion globally in AUM and likely to rise even further, some supervisors simply want to make sure that they are not missing any product that could be risky. In the back of their minds, some obviously wish to spot risks early on, unlike in the run-up to the last crisis with CDOs and ABS, only that ETFs share none of the latter products’ features.”
“If there is further regulation it would need to come from the ongoing work of IOSCO, possibly in the form of reviewing the 2013 IOSCO principles for the regulation of ETFs. We as an industry would get a bit concerned when seeing central bankers make policy recommendations because they are not necessarily familiar with some of the operational realities of the ETF market environment, as well as with the details of existing legislation as enshrined in several key pieces of EU securities law” adds Cupelli.
The ECB report also acknowledges that the liquidity transformation performed by ETFs, ‘while subject to frictions’ is a key benefit to investors.