FSB concerned about counterparty and liquidity risk in ETF market

FSB warns of counterparty risk due to rapid growth of synthetic ETF market; also expresses concern about on-demand liquidity in stressed conditions, particularly linked with vertically integrated providers.

The Financial Stability Board (FSB) has warned there are stability risks being created in some areas of the exchange-traded funds (ETF) market. It believes the recent acceleration in growth of synthetic ETFs in some Asian and European markets warrants further scrutiny. It is also worried about the potential impact of heavy ETF trading on the liquidity and price dynamics of the referenced securities, particularly if they do not have an active secondary market such as emerging market ETFs.

In a paper entitled Potential financial stability issues arising from recent trends in Exchange-Traded Funds, the FSB recognises that recent innovations in the ETF market have seen products branch out to new asset classes such as fixed-income, credit and commodities. But it warns: "The drivers and implications of the recent wave of financial innovation in ETF markets warrants closer surveillance of potential vulnerabilities by financial stability authorities."

In particular, the FSB says the rapid development of synthetic ETFs, which involve entering into swaps contract with counterparties, need closer scrutiny. It believes the growth in European regulated products, including Ucits funds, may be due to European regulators taking a more liberal stance on the use of derivatives in investment funds compared with their peers in the US.

Another factor is accounted for by the synergies created within a banking group, where, for example, the provider - typically a bank's asset management arm - sells ETF shares to investors in exchange for cash invested in a collateral basket, which in turn is swapped by the derivatives trading desk of the same bank for the return of an index. "Since the swap counterparty is typically the bank also acting as ETF provider, investors may be exposed if the bank defaults," says the FBS. "Problems at those banks that are most active in swap-based ETFs may constitute a powerful source of contagion and systemic risk."

Marco Montanari, director and head of db X-trackers ETFs for Asia in Hong Kong, acknowledges the concern but points out there can also be bid/ask spread benefits for investors when a bank uses its own market makers. "There are synergies in these structures and, in the end, all the funds are obliged to respect best execution. So for our ETFs, Deutsche Bank can provide efficient conditions," Montanari says. "We welcome all market makers but having Deutsche Bank as official market maker can be an additional advantage... if you have to call an external market maker to provide prices then it needs to make profit for the service."

Other market participants believe synthetic ETFs have a role to play and that there are ways to mitigate risk. "iShares does have synthetic ETFs too, in response to appetite for hard-to-access markets. In these markets and some less traditional asset classes, you just can't offer exposure using plain vanilla ETF structures," says Anthony Chan, director of iShares Asia research and investment advisory at BlackRock in Hong Kong. "Our philosophy is to use a multi-dealer model to diversify counterparty risk."

The FSB surmises that imposing higher disclosure and reporting requirements, as well as regulatory and other limits, could help alleviate the risks emerging in complex instruments, and prevent the emergence of conflicts of interest.

The board also highlights the risks of heavy ETF trading on the liquidity and price dynamics of the referenced securities, especially during market stress and where there is no active secondary market as there is with some emerging market ETFs.

Volatile market swings in the ETF market following the Tohoku earthquake appear to demonstrate the validity of the FSB's concern. Chan says problems of using a vertically integrated model when the same bank is both ETF provider and market maker were exposed in the aftermath of the March 11 Tohoku earthquake and tsunami.

"After the Japan earthquake, spreads widened across several ETFs tracking Japan equities, but the market makers through our multi-dealer model were there throughout the day," says Chan. "In the vertically integrated model, with a single market maker, the sole market maker in one particular case disappeared, and for a large period of the day there was no market being made on that particular ETF."

Montanari believes trading in Asia mitigates some of this risk. "If investors trade ETFs having Asian underlyings, we advise them to trade those ETFs listed in Hong Kong and Singapore instead of those in the US and in Europe, as there is more transparency regarding pricing and you can compare the price of the ETFs with the underlying," he says. "While trading an ETF linked to an underlying that is not trading, the ETF becomes an independent animal that moves just on the basis of the demand of the ETF and not of the underlying."