A Game-Changer

April 15, 2011

It’s unlikely things can go on as before after this week’s flurry of warnings on ETFs.


[This blog first appeared on our sister site, IndexUniverse.eu.]


Conscious that I’m stepping into what is likely to be a brief hiatus between this week’s salvo of ETF-related warnings from the G20 Financial Stability Board, the IMF and the Bank for International Settlements, and a likely counterblast of official responses from ETF issuers, here are some initial thoughts.

My first impression is that this week will go down in history as having changed the way in which the ETF industry operates. It’s unlikely that things can go on as before, with a growing number of increasingly disparate fund (and non-fund) structures all being labelled with the same brand name. How this is all resolved is anyone’s guess, but an obvious conclusion is that the ETF issuer’s own good name is going to be even more important than before. Trust in the issuer will override belief in the product concept. The industry has been surfing on a wave of pro-ETF sentiment for too long, perhaps.

Second, the ETF market’s growth rate will slow, and could even pause or go into reverse. The focus in the BIS paper on regulatory arbitrage by banks—the use of ETFs as a funding mechanism for parent investment banks, with the maturity of the swap being used to disguise the fact that the bank is effectively receiving overnight funding from the ETF while also obtaining relief from key liquidity metrics for the calculation of bank capital requirements—raises serious questions about the whole business model of synthetic ETF replication.

A regulatory tightening in this area could make synthetic replication uneconomic, while even the maintenance of the status quo may make it difficult for synthetic ETF issuers to expand their operations (i.e., for banks to assign much more balance sheet usage for the writing of ETF-related swaps). And, without doubt, after this week’s flurry of ETF-related questions, plenty more risk managers and compliance departments are going to be asking questions about ETF structures—and, I’m guessing, not just at buy-side firms, but within issuers’ parent companies as well.

Third, the physical versus synthetic replication debate has been reignited (perhaps, more broadly, one should speak of the battle between those ETF issuers that come from a fund management background and those that are part of investment banks). iShares is the leading exponent of the physical replication model, while Lyxor and db x-trackers are the leading firms in the synthetic category. In addition, there are now also several hybrids combining elements of both business models (Credit Suisse, for example, and HSBC to a lesser extent).

It was noticeable that iShares was quickest off the mark in responding to the first policy statement this week, that of the FSB on Tuesday. Within 24 hours iShares had put out a press release, arguing that the FSB had hit the nail on the head by pointing out potential conflicts of interest where swap-based ETFs and their derivative trading counterparts are within the same bank. iShares also applauded the FSB’s highlighting of the risks that arise if a bank uses synthetic ETFs as an inexpensive source of funding for illiquid securities.

But did the FSB thereby give the green light for the physical replication model, as iShares implies? Hardly. According to the FSB paper’s authors: “Securities lending...may create similar counterparty and collateral risks to [those incurred by] synthetic ETFs. In addition, securities lending could make the liquidity position of the ETF fragile, by challenging the ability of ETF providers to meet unexpected liquidity demands from investors, particularly if outflows from ETFs become significant under severe stress. A prevalence of securities lending could create a risk of a market squeeze in the underlying securities if ETF providers recalled on-loan securities on a large scale in order to meet redemptions. In addition, the use of ETFs as collateral in a long chain of secured lending and rehypothecation may create operational risks and contribute to the build up of leverage."

That’s unequivocal. Meanwhile, the claim made by iShares’ European boss, Joe Linhares, in Wednesday’s press release, that the firm “has always been transparent about the revenues generated and the risk framework surrounding its [securities lending] activity” is stretching reality.