There may be other benefits for the bank under such an arrangement, the BIS continues. “The bank providing the total return swap through the unfunded swap ETF structure may benefit from a reduction in regulatory capital charges. This would be the case if lower credit quality and less liquid assets are included in the collateral basket sold to the ETF sponsor compared with those acquired for replicating the ETF index.”
And, says the BIS, the new Basel III capital regime for banks could also incentivize banks to offer synthetic ETFs. The liquidity coverage ratio (LCR), which has been described as the core component of Basel III’s liquidity regime, uses a concept called the “run-off rate”. A run-off rate is assigned to each source of bank funding and is designed to reflect the portion of that funding component that won’t roll over—i.e., be renewed—in the next 30 days. For a stable source of funding (bank deposits, for example) the run-off rate is low, typically 5% or 10%. For sources of funding that can evaporate quickly, the run-off rate is 100%.
Run-off rates are used under Basel III to model banks’ likely net cash outflows over a 30-day period under a stress scenario. Banks are then required to hold liquid assets (typically government bonds) in excess of such net outflows. The higher the run-off rates applied to sources of funding, the larger the portfolio of low-return, liquid assets the bank will have to hold, in other words, and the more constrained it will be in its activities.
As the BIS notes, “under the proposed LCR standard, unsecured wholesale funding, as well as secured funding backed by lower credit quality collateral assets or equities maturing within 30 days will receive a 100% run-off rate in determining net cash outflows.” But by contracting a swap with the ETF sponsor that might typically have a maturity greater than one year, then employing equities and lower credit quality assets to collateralise the swap, the bank will be able to reduce its run-off rate substantially, when compared with the rate for secured funding of shorter maturity, says the BIS—even though the bank’s option to substitute different collateral into the ETF’s substitute basket on a daily basis means that it is effectively being funded overnight.
In the concluding section to its working paper the BIS goes on to theorise about the broader threats to systemic financial stability that may result from the rapid growth of the ETF market.
First, the BIS notes that in promising an index return to a synthetic ETF, the (bank) provider of a swap is assuming a contractual liability that is not related to its core business. “The risk (for the swap provider’s trading desk) of underperformance or tracking error might be co-mingled with the rest of the trading book risk. This could potentially undermine the oversight function and compromise sound risk management,” argues the BIS.
Additionally, there’s no guarantee that the swap provider will be able to stand up to its index-tracking guarantee in extreme market conditions, says the BIS. “The capacity of the swap counterparty to bear the tracking error risk while providing the market liquidity needed when there is sudden and large liquidation of ETFs is untested,” it asserts.
Indeed, the BIS argues, a surge of ETF sale orders and redemption requests could lead to a more dangerous negative feedback loop, potentially affecting the stability of the parent bank of the (synthetic) ETF provider.
“Sudden and large investor withdrawals triggered by market events or counterparty risk concerns can also lead to funding liquidity risk,” says the BIS. “This risk can propagate through the investment banking function, which might take for granted the access to cheap funding through the swap arrangement with the ETF sponsor. The cheap funding is secured by marketing a tradeable index portfolio through the ETF sponsor, but not charging investors adequately for the liquidity option that they have been granted.
“Swap providers do not take into account the effect this can have on aggregate liquidity risk, which is an externality to them. Because ETF redemptions will require cash to be delivered against collateral assets that might be illiquid, market-making activities could be severely hampered, as funding these assets might take priority. The collapse of funding for individual financial intermediaries could then reinforce funding stresses for the financial system as a whole.”
Above all, concludes the BIS, there’s a dangerous potential mismatch between investors’ assumptions about the liquidity of their ETF investments and reality, something that the recent credit crisis should have warned us about.
“Experience has shown that market risk assessments tend to be closely tied to the underlying assumptions about the market liquidity of products. The notion that the market for ETFs is liquid might lead to the market risk of these products being underestimated. Under these circumstances, a reassessment of the market liquidity of ETFs by investors can have significant implications for the normal functioning of financial markets.”
The FSB, then the IMF, and now the BIS, all within a week. For the three institutions entrusted with global financial stability to sound consecutive alarm bells about a single area of the market is surely unprecedented. How will ETF investors react? And how will fund providers respond?