The Bank of England’s latest financial stability report has turned its attention to the increasingly cumbersome issue of Exchange-Traded Funds (ETFs), which have recently come in for some criticism over their growing complexity and lack of transparency.
As the Bank notes, the products do offer some great advantages to the market.
Above all, they provide a wider population than ever before access to a very extensive range of instruments, in a reasonably liquid form. Furthermore, they’re low cost and have a good track record in keeping up with the performance of their indices.
Having said that, the Bank spends much more time outlining their potential risks.
As it observes:
While offering a number of benefits, ETFs also potentially bring some risks to the financial system, and these will need watching
Among the areas it is watching, it says, are the mechanisms that insure intraday liquidity management, including high frequency trading and the voluntary nature of the liquidty providers:
Market makers typically provide continuous intraday liquidity in ETFs so are exposed to changes in the value of the shares between trading with investors and closing out those positions with the fund.
These exposures are hedged, often through high frequency trading, especially in equities. This hedging helps arbitrage price differences between the fund’s share price and the underlying securities.
Sizable deviations are possible where underlying securities are not highly liquid, however. Commodity ETFs are reported to be most prone to these deviations. And market makers are not obliged to make markets at all times, so may withdraw liquidity in volatile markets, exacerbating differences between the value of the fund and the underlying securities.
The Bank also appears worried about leveraged funds, which are disproportionately popular among ETF investors:
ETFs offering leveraged returns represent only around 3% of the ETF market. But turnover is on average much higher than for funds offering unleveraged returns, with leveraged return funds accounting for around 20% of daily turnover according to contacts.
Investors in ETFs offering leveraged returns include those not permitted to hold derivative positions in the underlying assets. The leverage offered may amplify dislocations between fund value and the underlying index. It is very important that this should be watched going forward. As in other areas, there would be potential for a basically good market to be undermined over time if it becomes dependent on leverage.
And then there are the transparency issues associated with the collateral underpinning the ETFs.
The BoE also notes the hidden counterparty risks:
Physical ETF providers aim to replicate the returns of the underlying index by either purchasing the relevant securities or by using assets that are correlated with the index.
Providers can then generate additional return through securities lending. Investors in the fund may benefit from such income through lower fees charged on the ETF, although the provider will often take a share.
Some contacts have questioned the transparency over the securities lending part of some ETFs, including with regard to reinvestment guidelines and associated risks. One risk is that in the event of failure of the firm providing the ETF, the ETF investor could end up holding something other than the intended index exposure and possibly face liquidity constraints on exiting their investment. Given the unfortunate developments in the securities lending markets in the run up to the current crisis,(1) this should not be under emphasised.
As for swap-based ETFs:
Swap-based ETFs are more complex than physical funds, usually using total return swaps (TRS) to gain exposure to an index. The provider typically sells shares in the ETF for cash which is invested in a collateral basket containing securities of similar quality to those in the underlying index.
The return on this basket of securities is then swapped for a floating rate which is then paid to the TRS counterparty against payments in line with the underlying index (Chart B).
Swap-based funds would be expected to see lower transaction costs than physical funds, and according to some contacts, would expect to have smaller tracking errors. However, counterparty credit exposure is embedded in the funds through the various derivative transactions; and in complex ways.(2)
The Bank concludes:
The growth of ETFs has been rapid and their use is broadening out across and within asset classes and new forms of the product are being offered. One risk is that the benefits of ETFs become outweighed by complexity, opacity and contingent risks. Swap-based ETFs have already come in for some criticism for their complexity, while a number of ETFs are not fully transparent about the risks arising from securities lending and counterparty risks from derivative exposures. It is important that the industry does not overreach when innovating in the ETF arena; the industry and regulators have an interest in the integrity and resilience of the market.
Now, where was that BoE factbox about CDOs?
Update 15:45: We have a response from the Bank of England, the factbox on CDOs was actually in Box 2 on p. 21 of the July 2006 FSR and very prescient it proved too. For example:
Systemic stability also relies on investors knowing what risks they are bearing. The very complexity of these instruments makes it difficult for investors to determine precisely how exposed they are to particular risk factors. The potential losses, and hence the market values, of CDO tranches are dependent on default correlations within the existing portfolio, which are difficult to calibrate. Modelling difficulties can also lead to errors in hedging, so traders can find themselves with residual exposures that they thought they had hedged. In such situations, they may wish to reduce the residual exposure if credit losses rise. But with the liquidity of CDO markets still developing, especially for some of the more complex instruments, a shortage of secondary market liquidity could potentially amplify price movements in the event of a shock.
Related links:
When is a market maker not a market maker? – FT Alphaville
How ETFs fueled high frequency trading - FT Alphaville
ETFs and the ‘flash crash’ – FT Alphaville