Global regulators raise fears over exchange traded funds

By Guest Contributor
May 25, 2011

By Christopher Elias

LONDON, May 24 (Business Law Currents) Promising low tax and returns from even the most unlikely of assets, the market in exchange traded funds (ETFs) shows no sign of slowing down. Fears of systemic risk are, however, causing some global regulators to rethink the growth of synthetic ETFs.

With ETFs having all the hallmarks of a troubling financial innovation, regulators are raising concerns over the growth of exchange traded funds and their ability to have unintended consequences for the financial industry. As ETFs are capable of taking the form of derivatives on derivatives, a comparison with collateralised debt obligations (CDOs) is not unwarranted, leading many to conclude that exchange traded funds might have the same explosive potential as CDOs had in the subprime crisis.

EXCHANGE TRADED FUNDS

By way of background, an ETF is an investment fund traded on a stock exchange that holds assets such as shares, commodities or bonds. The majority of ETFs track an index such as the FTSE 100 and can be an attractive investment due to their low costs, tax efficiency and share-like features. Giving a cheap and effective way to track an asset class, they have proved increasingly popular, particularly in the U.S. where they have been around for a number of years.

Innovation in the ETF market has meant that increasingly investors are gaining exposure to a more and more diverse basket of assets including gold, developing economies, infrastructure, or even water. Using derivatives and leveraging, ETFs can create financial connections between quite unlikely sections of the financial community and their use is generating concern that they may be creating a new form of systemic risk.

 

ETF FANS

Not everyone is so negative about ETFs, however. A number of investment banks have been singing their praises of late. Among those promoting the ETF sector is Credit Suisse who disclosed recently that it has expanded its range of ETFs to 58, including two equity and two money market funds on the SIX Swiss Exchange. The additional ETFs make Credit Suisse the largest ETF provider in Switzerland.

Société Générale, the French bank, has also been active in the ETF market. It offers a range of currency, commodity and thematic ETFs, including Lyxor ETF World Water (TR), a fund whose objective is to track the World Water Total Return IndexCW. The World Water Total Return Index is an index consisting of the 20 largest companies in the fields of water utilities, water infrastructure and water treatment. In fact, Société Générale has become a leading European provider of synthetic ETFs offering funds that cover anything from agriculture and livestock to uranium.

 

PLAIN-VANILLA VS. SYNTHETIC

As the market in ETFs has grown in size, so has the level of complexity and diversity of ETF products. Broadly speaking, there are two different types of ETFs: “plain-vanilla” products and “synthetic” ETFs. Plain-vanilla ETFs work by replicating the index they are linked to by simply reconstituting the basket of physical securities underlying the index. For example, an S&P 500 ETF might simply buy a selection of S&P 500 shares with appropriate weighting. The resulting fluctuation in the value of the basket shares will then reflect at least approximately the changes in the overall index.

Synthetic ETFs, on the other hand, work through entering into asset swap, i.e., an OTC derivative, with a counterparty, rather than physically replicating the index. Synthetic ETFs of this sort allow ETFs to enter into a greater number of transactions and present the possibility of investing in assets where physical holding of the asset is not possible.

The rapid development of synthetic ETFs in Europe has seen them capture 45 percent of the ETF market and their numbers are growing. Fueling this growth, according to the Financial Stability Board (FSB), are the cost synergies created within banking groups. With derivative trading desks acting as swap counterparty to the bank’s own asset management arm, it is easy and cost effective for investment banks to produce synthetic ETFs. Further, while U.S. regulators mull over restrictions on the use of derivatives in ETFs, European ETF regulation has been minimal. In fact, ETFs are covered by UCTIS III regulation, allowing the use of certain derivatives for investment as well as hedging purposes.

 

SYNTHETIC ETFs

Allowing investors to bet on the return of a seemingly infinite variety of assets, synthetic funds allow speculation on a scale many times the multiple of their plain-vanilla cousins. With no need to physically hold an asset, speculation is only restricted by the extent of a bank’s imagination, and many banks have been quick to put their financial dreams into reality.

Morgan Stanley has also been actively investing in ETFs. It recently published final terms for 1.5 million warrants linked to shares in a gold ETF by the name of “Gold Bullion Securities Limited.” Linking investors to the ETF market, the warrants allow investors to track the performance of the gold spot prices without physically holding gold. Instead investors buy warrants which are pegged to units in the exchange traded fund, which in turn holds gold.

For those looking for even more complexity and perhaps even higher returns, Santander has prepared a capital-at-risk equity and fund linked redemption notes under a €10 billion structured note programme. The notes form a fund of funds, allowing investors to invest in a basket of indices, which include iShares MSCI Emerging Market Index Fund, a U.S. ETF providing exposure to emerging markets.

 

ETF FOES

This bundling of funds together has caused some regulators to raise concerns about how adverse market conditions might affect ETFs and the financial industry generally. The Financial Stability Board, the International Monetary Fund, and the Bank for International Settlements have all raised concerns about ETFs in recent months, with each of them issuing separate reports on ETFs and their potential to create systemic risk.

The Financial Stability Board (FSB), the global body that coordinates financial regulators, published a report entitled “Potential financial stability issues arising from recent trends in Exchange-Traded Funds (ETFs)” as recently as April. Synthetic ETFs are directly in the FSB’s sights.

According to the FSB, ETFs raise new challenges in terms of counterparty and collateral risks (think Lehman Brothers!) and the expectation of on-demand liquidity creates the conditions for acute redemption pressures (think Northern Rock!). These problems are exacerbated in the case of synthetic ETFs, where a bank may be acting as both ETF provider and swap counterparty. This combination of functions means that investors may become exposed if a bank defaults, potentially creating a “powerful source of contagion and systemic risk.”

The FSB also criticized the synthetic ETF market for not aligning incentives along the ETF chain. The FSB noted that the synthetic ETF creation process may be driven by a bank’s wish to raise funding against an illiquid portfolio that cannot otherwise be financed in the repo market. This means that banks may be tempted to offload illiquid assets to investors in the form of ETFs, a move that may cause liquidity pressures, should the ETF market suffer unexpected liquidity demand.

The FSB’s conclusion was that ETF markets “warrant closer surveillance of potential vulnerabilities by financial stability authorities to ensure that the market grows in a sustainable and safe way.” With the regulatory clamour over ETFs intensifying, further regulation of this expanding area is surely only a matter of time.

(This article was first published by Business Law Currents, a leading provider of legal analysis and news on governance, transactions and legal risk from Thomson Reuters Accelus. Visit Business Law Currents online at http://currents.westlawbusiness.com.)

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