International regulator conspiracy? Unfortunate coincidence for the ETF industry? Or are regulators finally on to something via the power of group think?
We ask because hot on the heels of the Financial Stability Board’s warning about exchange traded funds on Tuesday comes “Annex 1.7″ of the IMF’s latest Global Financial Stability report, entitled ETF Mechanics and Risks.
Here goes the summary (our emphasis):
Exchange-traded funds (ETFs) have become increasingly popular over the past few years. They give investors increased access to emerging market assets while also offering flexibility and leverage to specialized investors. Traditionally, ETFs have physically held underlying assets, but a new breed of ETFs have emerged in Europe that use synthetic replication techniques and derivatives to reduce costs and thereby boost returns. A small percentage of these funds also use leverage to cater to the hedging needs and speculative positions of their nonretail client base.
While these enhancements have reduced costs, they add a layer of complexity and increase counterparty and liquidity risks. The disproportionately large size of some ETFs compared with the market capitalization of the underlying reference indices poses a risk of disruptions in some markets from heavy ETF trading. This annex surveys the growth and mechanics of ETFs and highlights some of the key risks pertaining to synthetic replication and the use of leverage and derivatives in ETFs.
And here are some preliminary golden nuggets we’ve plucked from the rest of the annex.
On basket optimisation for liquidity purposes in the US:
U.S.-based ETFs typically use the physical replication technique due to regulatory constraints.63 When underlying securities are illiquid or unavailable or transaction costs are significant, ETF managers use portfolio sampling techniques to match index returns closely without using full replication.
On non-delta one products:
Newer types of ETFs, such as leveraged and inverse ETFs, offer magnified and inverse returns on the performance of an index and use derivatives to match benchmark performances closely, all of which adds layers of complexity and poses higher risks to investors. In 2010:Q3, leveraged and inverse ETFs constituted around $41 billion of total ETF assets (less than 5 percent of total assets under management), with exposures primarily to US equities.
On synthetic replication in Europe:
Current regulations in Europe on swapbased ETFs mitigate some of this credit risk, as they impose minimum requirements on cash and securities holdings to pay investors if a counterparty defaults. However, given that a majority of European ETF providers use the synthetic replication method, the gross exposures of these funds raises some concerns on whether current restrictions on derivative contracts are sufficient to curtail counterparty risks from becoming systemic under stressed market conditions.
On liquidity risk:
Illiquid assets, reduced market access, and a dearth of derivatives in some emerging markets, combined with the sudden exit of market makers can exacerbate volatility under stressed conditions. While most ETFs are supported by one or more market makers, there is no guarantee of active trading under illiquid conditions. Analysts point to the so-called flash crash in May 2010 as an example of the risks ETFs are susceptible to, when market makers were overwhelmed by a surge in computer-driven selling.
On footprints in commodity markets:
Gold ETF funds received net inflows of around $12 billion in 2009 and another $9 billion in 2010 as prices surged 62 percent in the two years to over $1,400 an ounce.72 However, flows sharply reversed course in January 2011, with $3 billion in outflows in one month alone, driving prices sharply lower .
Such dynamics raise concerns that a reversal of investor flows from other commoditybased funds could potentially increase volatility in the broader market and influence price action in related sector indices.
On waterfall structures:
Bankruptcy laws surrounding counterparty defaults and the potential freezing up of collateral at custodial banks remain areas of concern for ETFs involved in TRS and securities lending. In a variation of the swap-based ETF, the provider sometimes transfers all the cash from investors to the TRS counterparty, which in turn pledges collateral to the ETF’s account at the fund’s custodian bank.73 In such a scenario, if the swap counterparty were to default, it could potentially lead the bankruptcy administrator to freeze all ETF assets, preventing the ETF from liquidating its assets if the need arises. Also, the TRS counterparty has an incentive to provide lower-quality collateral in such an exchange, leaving the ETF provider with potentially illiquid assets to offload in the case of a default of the counterparty.
Plenty to chew over.
Related links:
The IMF on the state of Europe’s banks – FT Alphaville
ETF systemic risks concerns raised by IMF - FT
Kauffman: ETFs are the problem, not HFT – FT Alphaville
Do banks see ETFs as inexpensive funding for illiquid securities? – Part I – FT Alphaville
Do banks see ETFs as inexpensive funding for illiquid securities? – Part II - FT Alphaville