In a paper published in April, the Financial Stability Board examines the recent rapid growth and innovation in the market for Exchange Traded Funds (ETFs), and highlights a number of recent developments that call for attention by regulators, as well as by the ETF industry, including providers, market-makers and investors. The paper draws some comparison between US and EU ETFs, as well as between what it calls "plain vanilla" ETFs, and more complex ETFs like synthetic ETFs, leveraged ETFs, inverse ETFs, and leveraged-inverse ETFs. Though applauding the ETF industry on its innovation and relative success, the paper points out some sources of vulnerability for both the ETF industry as well as those posed by ETFs to the larger financial markets. Among these are the risks introduced by the ETF industry on market liquidity during times of stress, particularly in an event of of a market sell-off or an unwind in any particular ETF. In such instances, there is a risk that investors massively demand redemption, and the FSB urges further study assessing the potential effect of heavy ETF trading on the liquidity and on referenced securities' price dynamics in the event they do not have an active secondary market (e.g. emerging market ETFs).
The FSB also sees some areas of risk for what they term "plain vanilla" ETFs as well, particularly with regard to heavy securities lending.
In the same vein, thin margins on plain-vanilla physical ETFs create incentives for providers to engage in extensive securities lending in order to boost returns. Some ETF providers are said to generate more fee income from securities lending than from their traditional management fees. Since securities lending is a bilateral collateralised operation, it may create similar counterparty and collateral risks to synthetic ETFs. In addition, it could make the liquidity position of the ETF fragile, by challenging the ability of ETF providers to meet unexpected liquidity demands from investors, particularly if outflows from ETFs become significant under severe stress. A prevalence of securities lending could create a risk of a market squeeze in the underlying securities if ETF providers recalled on-loan securities on a large scale in order to meet redemptions. In addition, the use of ETFs as collateral in a long chain of secured lending and rehypothecation may create operational risks and contribute to the build up of leverage. In this regard, it is worth noting that some jurisdictions impose reporting and disclosure requirements (e.g. on-exchange registration) on securities lending that would contribute to lower risks.
The FSB urges regulators and ETF market participants to reexamine the risk implications of the recent growth, development, and innovation in the ETF market.
In view of the new challenges raised by recent trends on ETF markets, ETF providers and investors should review the risk management strategies of ETFs, especially in areas such as counterparty risk and collateral management, as well as assessing their exposure to market and funding liquidity risks. Furthermore, ETF providers should consider enhancing the level of transparency they offer to investors on the entire range of ETF products, especially the more complex ones. In particular, they should make publicly available detailed frequent information about product composition and risk characteristics, including on collateral baskets and arrangements for synthetic ETFs and securities lending, to enable investors to exercise their due diligence and promote a better understanding of the ETF market at large.
The full text of the paper is available at: http://corpgov.net/wp-content/uploads/2011/06/FSB-ETFs-StabilityIssues.pdf