The FSB, the IMF and the BIS wave red flags over ETFs in separate publications released on consecutive days.
[This article first appeared on our sister site, IndexUniverse.eu.]
Launching a barrage of warnings, global financial policymakers at the International Monetary Fund (IMF) and the Bank for International Settlements (BIS) have followed the G20 Financial Stability Board (FSB) in raising concerns about the exchange-traded fund market.
Following Tuesday’s publication of a note on ETF market risks by the FSB, on Wednesday the IMF devoted six pages of its latest half-yearly Financial Stability Report to ETFs, focussing on “Mechanics And Risks”. On the same day the BIS released a working paper by Srichander Ramaswamy of its Monetary and Economic department, entitled “Market structures and systemic risks of Exchange-traded funds”.
Following a brief description of the ETF market’s growth and of the mechanics of exchange-traded funds, the IMF stability report categorises five specific risks that it sees as inherent to ETFs: counterparty and mark-to-market risk for the ETF provider; leverage risk for investors; liquidity risk; market disruptions; and legal and policy risks.
In the section devoted to counterparty risks, the IMF highlights the credit risk to the swap provider to which an investor in those (mainly European) ETFs that use synthetic replication to track their benchmarks is exposed. While accepting that under Europe’s UCITS rules such credit risk is mitigated by the use of offsetting collateral, the IMF argues that “the gross exposures of these funds raise some concerns on whether current restrictions on derivative contracts are sufficient to curtail counterparty risks from becoming systemic under stressed market conditions”.
Where securities lending is undertaken by funds using physical replication to track their index benchmarks, the IMF notes that, while “regulation currently requires ETF providers to be able to recall securities lent at a short notice and to adequately collateralise such lending”, risks arise from the typical lack of transparency surrounding the securities lending activities undertaken by ETFs and since “cash reinvestment guidelines have not been clearly laid out by regulators.”
In the section called “liquidity risk”, the IMF points out that “while most ETFs are supported by one or more market-makers, there is no guarantee of active trading under illiquid conditions”, citing last May’s flash crash as an example of the risks to which exchange-traded funds are potentially exposed.
The IMF cites flows into commodity-tracking ETFs as a cause for concern, in particular that these inflows are “distorting prices away from fundamental factors”. The recent rise in the price of gold is given as an example of such an ETF-inspired trend. “A reversal of investor flows from other commodity-based funds could potentially increase volatility in the broader market and influence price action in related sector indices,” argues the IMF.
There are significant legal and policy risks associated with ETFs, particularly in regard to the use of derivatives and securities lending, says the IMF. If an ETF uses a fully funded swap (where the fund provider transfers investors’ cash to the swap counterparty, which in turn pledges collateral to the ETF’s account at the fund’s custodian bank), there is a risk that in the case of the failure of the counterparty the bankruptcy administrator could freeze the ETF’s assets, preventing it from liquidating them, says the IMF. In addition, the swap counterparty has an incentive to provide lower-quality collateral to the ETF, notes the IMF, leaving the provider with potentially illiquid assets to offload in the event of a counterparty default.
Finally, the IMF says, some ETFs have been designed to exploit dividend withholding tax-related arbitrage opportunities between two regional jurisdictions. These strategies have been a source of friction between local authorities and foreign investors, notes the IMF, leaving such funds exposed to sudden policy shifts aimed at closing the tax loopholes.
In its working paper on ETFs, the BIS goes into considerably more detail than the IMF. The BIS paper’s author, Srichander Ramaswamy, examines the nuances of synthetic ETF structures and their associated risks, the economic incentives that are driving the growth in synthetic tracker funds and the possible opportunities for regulatory arbitrage that ETFs present. Ramaswamy also notes wider systemic risks to the financial sector that may result from the widespread adoption of such ETFs.
The BIS notes that synthetic (swap-based) ETF structures have become popular as a way of reducing the potential tracking error problems that occur when ETFs’ traditional technique of physical replication (buying the underlying index securities) is used in less liquid markets.
But, says the BIS, there are two distinct types of synthetic ETF—using funded and unfunded swaps—with resulting differences in the counterparty risks assumed by the end investor, and also with differing balance sheet implications for the bank providing the swap to the fund.
In an ETF following the unfunded swap structure, the ETF sponsor exchanges cash with the swap counterparty for ownership of a basket of collateral. The ETF sponsor also contracts with the counterparty to pay it the return on the collateral basket, while the counterparty pays the index return to the ETF sponsor (and thereby to the fund’s investors).
Since it becomes the beneficial owner of the collateral basket, the ETF sponsor can sell the basket’s securities in the case of a counterparty default and then repay the fund investors, says the BIS.
By contrast, the second type of synthetic ETF, using funded swaps, sees the payment of cash by the fund sponsor to the swap counterparty, who simultaneously contracts to pay the index return to the sponsor. This contractual obligation is secured by a pledge of collateral “into a ring-fenced custodian account to which the ETF sponsor has legal claims,” says the BIS. “But unlike in the unfunded swap structure”, the BIS continues, “the sponsor is not the beneficial owner of the collateral assets. This can potentially lead to delays in realising the value of collateral assets if the swap counterparty fails.
Offering a synthetic ETF range gives a cheap source of financing to a bank, the BIS says, noting that firms involved in market-making activities need to finance their inventories of stocks and bonds. If these inventories are illiquid, they will have to be funded either in the unsecured markets—expensively—or in repo markets, using deep haircuts (discounts to face value).
However, continues the BIS, “by transferring these stocks and bonds as collateral assets to the ETF provider sponsored by the parent bank, the investment banking activities may benefit from reduced warehousing costs. Part of these cost savings may then be passed on to the ETF investors through a lower total expense ratio for the fund holdings”.
But, says the BIS, echoing the IMF’s argument, the poorer the quality of the assets posted to the ETF as collateral, the greater the cost savings accruing to the investment bank. In other words, there’s an economic incentive to post illiquid securities to the ETF, reducing investors’ security.
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?