The Liquidity Challenge

May 23, 2012

Europe’s fund rules and regulators’ macroeconomic objectives may clash, leaving ETFs in an uncertain position.


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Exchange-traded funds have flourished by offering investors access to a broadening range of asset classes at the click of a button. But is their promise of instantaneous liquidity now an increasing concern for those charged with monitoring the safety of the global financial system?

An intense debate continues about the complexity of non-bank financial institutions and activities that constitute the so-called “shadow banking” system.

“Regulators involved in these discussions are primarily concerned with two issues,” said Simon Gleeson, a partner at law firm Clifford Chance, addressing last week’s Inside ETFs Europe conference during a session devoted to the regulatory outlook.

“First, they’d like to have a policy tool that they can use to regulate credit creation without resorting to monetary policy. Second, they are concerned with liquidity transformation and they would like to create a set of rules to inhibit people from borrowing too much at short maturities while investing long-term.”

“As far as the funds industry is concerned,” continued Gleeson, “it’s the liquidity question that’s paramount.”

Regulators’ shadow banking concerns started with money market funds (MMFs), Gleeson reminded the audience. MMFs are criticised by some observers as offering what is effectively a deposit-taking function, but without the capital requirements that bank regulators insist on. However, current worries about liquidity transformation apply to the entire funds industry, including ETFs, Gleeson said.

“Retail funds such as UCITS are marketed on a promise of being redeemable within three days. In fact, money is raised in this way across the whole asset management industry and then deployed in securities with maturities of months or years,” he went on.

There’s a danger, though, that by tightening controls on shadow banking regulators will impact growth, said Liam Butler, head of ETF fund administration at Northern Trust and co-panellist during last week’s debate.

“What’s going on in funds, including ETFs, is real commercial activity,” said Butler. “As long as you have proper risk management processes in place, much shadow banking activity is actually positive for the markets.”

European policymakers do understand that it would be foolish to crack down on capital markets activities per se, said Mirzha de Manuel, researcher at the Centre for European Policy Studies (CEPS), a Brussels-based think-tank.

“Some policymakers think that Europe’s economic recovery has been slower than that in the US precisely because of the more developed capital markets across the Atlantic,” said de Manuel.

“Europe’s fund regulators also consider that they’ve largely addressed the question of liquidity transformation,” continued de Manuel. “The UCITS rules are designed so that funds invest in liquid assets, whereas under the Alternative Investment Fund Managers Directive (AIFMD), which covers non-UCITS funds, you have to ensure that investors have a redemption policy that reflects the liquidity of the underlying assets.”

It would be unfair to single out ETFs in the current shadow banking discussions, said Alain Dubois, chairman of Lyxor, the third-largest issuer of ETFs in Europe.

“In its green paper on shadow banking the European Commission made it clear that it is looking both at specific entities and also at certain types of activity,” said Dubois. “Amongst the entities being looked at are investment funds in general, including ETFs. We’ve always said that ETFs are investment funds, no more, no less. There is one difference from most funds, in that ETFs are listed, but I don’t think this changes much.”

Nevertheless, fund regulators are questioning whether investors in ETFs may need additional protection. Europe’s securities market regulator, the European Securities and Markets Authority (ESMA) , posed the question in its recent consultation paper of whether issuers of ETFs should be forced to provide a guarantee of the possibility of direct redemption from their funds. Currently, only intermediary institutions called “authorised participants” can deal directly with ETF issuers to create and redeem fund shares. Other investors in ETFs have to buy and sell in the secondary market.

Requiring ETF managers to offer such a facility would be “problematic”, according to Northern Trust’s Butler, in view of the operational difficulties involved.



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