TWN Info Service on Finance and Development (Apr11/06)
23 April 2011
Third World Network

Systemic risks associated with exchange-traded funds
Published in SUNS #7134 dated 20 April 2011

Geneva, 19 Apr (Kanaga Raja) -- Exchange-traded funds, which are popular among investors seeking exposure to a diversified portfolio of assets, can contribute to a build-up of systemic risks in the financial system, especially when their returns are replicated through the use of derivative products.

This is the main conclusion of a new working paper by the Bank for International Settlements (BIS) titled "Market structures and systemic risks of exchange-traded funds".

The paper comes just as the High-Level Conference on Macro-Prudential Policy Frameworks took place on 17 April in Washington, on the sidelines of the IMF and World Bank's spring meetings, to discuss ways to reduce system-wide risks in the global financial system and how to improve the so-called macro-prudential policy framework.

According to a BIS press release, the conference was organized by the International Monetary Fund (IMF), BIS, and the Financial Stability Board (FSB).

[In a post on the "Naked Capitalism" blog, Yves Smith has noted that the IMF and the Financial Stability Board have also drawn attention to the systemic risks posed by the ETFs (exchange-traded funds), and says the three reports are laying the groundwork for clearer disclosure and tightening of some rules. But how quickly that happens and whether it gets the Eurobank affiliated funds out of the dodgy business of providing cash to their sponsors remains to be seen. See more below.]

The BIS press release of 18 April said that the global crisis exposed gaps in the public policy toolkit to deal with systemic risk that had far-reaching economic and social consequences in many countries. Macro-prudential regulation has become the new frontier of policy development to strengthen financial systems inside countries and across borders. Generally, it is defined as policy that uses primarily prudential tools to limit systemic or system-wide financial risk.

However, it added, beyond that general definition, the understanding of how and when to use what instruments in which situation remains at an early stage. Developing a policy framework to fill these gaps is an urgent challenge and has become the subject of widespread interest among policy-makers and academics.

The BIS working paper, authored by Srichander Ramaswamy, says that financial institutions are constantly designing and marketing innovative financial products that promise to meet investors' return expectations as market conditions and global risk appetite change.

For example, in the low global interest rate environment in 2002-03, structured credit products were marketed to gear up investment returns for institutional investors as the value of their liabilities increased; banks were also willing buyers as they offered higher returns to comparably rated plain vanilla assets. Rising investor demand for these products subsequently helped banks to fund the rapid growth in credit demand in 2004-06 through the securitisation structures that these products supported.

The financial crisis experience, however, dampened investors' appetite for structured credit products. Yet the low global interest rates that supported growth in structured credit products have returned, with institutional investors facing similar problems to those back in 2002-03.

This time, the paper says, financial intermediaries have responded by adding some innovative features to existing plain vanilla investment funds. These investment funds, marketed under the name of exchange-traded funds (ETFs), have existed since the early 1990s as a cost- and tax-efficient alternative to mutual funds. The structuring of these funds initially shared common characteristics with that of mutual funds. In particular, the underlying index exposure that the ETF replicated was gained by buying the physical stocks or securities in the index.

"In recent years, investors looking for alternative investment vehicles to structured products have turned to ETFs being marketed as plain vanilla-type flexible and transparent investment products that can be traded like stocks on an exchange. Investors' desire to seek higher returns by taking exposure to less liquid emerging market equities and other assets through ETFs that guarantee market liquidity has, however, demanded more innovative product structuring from financial intermediaries."

The paper notes that some of the product innovation might also be driven by dealer incentives to seek alternative funding sources to comply with the liquidity coverage ratio (LCR) standard under Basel III. For example, certain product structures might facilitate run-off rates on liabilities to be reduced despite keeping the maturity of liabilities short.

"As a result, ETFs have moved away from being a plain vanilla cost- and tax-efficient alternative to mutual funds to being a much more complex and diverse array of products and replication schemes."

The working paper goes on to examine recent market developments in ETFs and their potential implications for financial market stability as growth of ETF assets under management gathers pace.

According to the paper, ETFs are structured as open-ended mutual funds that allow investors to gain diversified exposure to financial assets across geographical regions, sectors or asset classes. They are traded on exchanges through brokers on a commission basis like stocks, which means that long and short positions can be taken; market, limit or stop orders can be executed; and they can also be purchased on margin.

As of end-2010, there were close to 2,500 ETFs offered by around 130 sponsors and traded on more than 40 exchanges around the world. Global ETF assets under management rose from $410 billion in 2005 to $1,310 billion in 2010.

Even so, says the paper, ETF assets under management remain a small fraction of the global mutual fund industry, which had close to $23 trillion in assets under management in 2010. About 80% of ETF assets in Europe are held by institutional investors, whereas in the US, their share is only 50%, with the remainder held by retail investors. Hedge funds are large users of ETFs in the US, but they trade less frequently in the ETFs originated in Europe.

In the early phase of the development of the ETF industry, index replication was done through plain vanilla structures that involved buying all the underlying securities comprising the index. Subsequent modifications involved replicating the index by holding an optimised basket of the underlying securities in the index and generating additional income by lending the securities out.

The paper notes that in the US, this involved organising ETFs as open-ended funds rather than as UITs (unit investment trusts) because UITs do not permit securities lending. Almost all of the ETFs that are benchmarked against fixed income or equity indices in the US are plain vanilla structures that involve physical replication of the underlying index. In Europe, roughly 50% of the ETFs are plain vanilla types, and the rest are replicated using synthetic structures.

The paper explains that synthetic ETFs allow replication of the index using derivatives as opposed to owning the physical assets. One motivation for using synthetic structures to replicate the index could be to reduce costs. If the index has a narrow regional or sector focus and is widely traded, replicating the ETF benchmark by owning the underlying securities can be cost-efficient.

However, it adds, physical replication can be an expensive method for tracking broad market indices such as emerging market equity or fixed income indices, or other less liquid market indices. Including only a subset of the underlying index securities for physical replication can lead to significant deviation in returns between the ETF and the index in volatile market conditions. Furthermore, in less liquid markets, the wider bid-ask spreads increase replication costs, particularly when the fund has high turnover.

The above considerations have led to the use of synthetic structures to replicate the ETF benchmark. One popular synthetic structure involves the use of total return swaps, which the ETF sponsors refer to as the unfunded swap structure, the paper observes.

Under the synthetic replication scheme, the authorised participant receives the creation units from the ETF sponsor against cash rather than a basket of the index securities as in the physical replication scheme. The ETF sponsor separately enters into a total return swap with a financial intermediary, often its parent bank, to receive the total return of the ETF index for a given nominal exposure.

This constitutes the first leg of the swap. Cash is then transferred to the swap counterparty equal to the notional exposure. In return, the swap counterparty transfers a basket of collateral assets to the ETF sponsor. The assets in the collateral basket could be completely different from those in the benchmark index that the ETF tries to replicate. The total return on this collateral basket is then transferred to the swap counterparty, which constitutes the second leg of the total return swap.

The nature of the swap transaction above suggests that this structure exploits synergies between banks' collateral management practices and the funding of their warehoused securities. This could provide another motivation for employing synthetic replication schemes, with the ETFs' parent financial institution using them as a funding vehicle for its warehoused securities, says the paper.

According to the paper, an alternative replication scheme used by ETF sponsors is to employ the so-called funded swap structure. Under this, the ETF sponsor transfers cash to the swap counter-party, who then provides the total return of the ETF index replicated. This transaction is collateralised, with the swap counter-party posting the eligible collateral into a ring-fenced custodian account to which the ETF sponsor has legal claims. But unlike in the unfunded swap structure, 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 counter-party fails," the paper cautions.

One special case of ETFs that use synthetic replication schemes is those that provide exposure to commodity markets. But in these markets, a lack of sufficient diversification of assets in the index prohibits the use of the mutual fund structure. As a result, exchange-traded products that provide exposure to commodities use other trust structures and are marketed as exchange-traded commodities (ETCs). While physical replication of some commodity indices, such as gold and copper indices, is used by sponsors, synthetic replication using futures or forward contracts is more common.

"As the demand for ETF assets has grown, so have product complexity and investor risk appetite for the product. More exotic products that provide leverage under the ETF umbrella are now being marketed to cater to the investor demand."

These products go by the name of leverage ETFs and deliver returns that are multiples of the daily performance of the index or benchmark they track. Another comparable product, the leverage inverse ETF, seeks to deliver a return that is a multiple of the inverse performance of the underlying index.

The swap-based replication schemes are usually employed by the ETF sponsors to deliver the investment performance on such products. While the assets under management of leverage or inverse ETFs amount to only around $40 billion globally, which is about 3% of ETF assets, they account for nearly 20% of the turnover in ETF assets, suggesting that they are very actively traded.

As to the motives for synthetic replication, the paper asserts that synthetic replication schemes transfer the risk of any deviation in the ETF's return from its benchmark to the swap provider, which is effected by entering into a derivatives contract to receive the total return of the benchmark. This protects investors from the tracking error risk which physical replication schemes would otherwise expose them to.

However, the paper adds, there is a trade-off: the lower tracking error risk comes at the cost of increased counter-party risk to the swap provider. ETF sponsors tend to emphasise the lower tracking error and downplay the counter-party risk to support the case for synthetic replication schemes, which are also marketed as being cheaper than the alternative method of replicating the index in the cash market.

"In reality, the increased popularity of ETF products among investors has led to greater competition between ETF sponsors, forcing them to seek alternative replication techniques to optimise their fee structures."

The paper notes that liquidity regulation, such as the standards now proposed under Basel III, may also create incentives to use synthetic replication schemes. For example, under the proposed LCR (liquidity coverage ratio) standard, unsecured wholesale funding provided by many legal entity customers (banks, securities firms, insurance companies, fiduciaries, etc) 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.

By employing equities and lower credit quality assets to collateralise the swap transaction with the ETF sponsor that might typically have a maturity greater than one year, the bank engaging in this swap transaction will be able to reduce the run-off rate substantially on the collateral posted. Yet, the collateral substitution option allows banks to effectively keep the maturity of the funding short. The bank will still face a cash outflow run-off rate of 20% for valuation changes on the collateral posted, but this is far lower than the 100% run-off rate that it might otherwise face.

"When significant volumes of such transactions are done, this may result in a substantial improvement in the banks' LCR, which would make compliance with the LCR standard less expensive."

Addressing the risks to financial stability, the paper finds that as the market share of assets and the number of players in the ETF industry have grown, increased competition has led to lower fund management fees for investors, and, at the same time, a wider range of financial market indices are now being replicated.

ETFs also offer a number of other benefits to investors: they allow the taking of short positions to hedge existing exposures cheaply; being liquid, they allow institutional investors to use them for transition management when switching mandates across asset managers; and they are suitable as a vehicle for implementing tactical asset allocation decisions that might target particular market sector exposures.

"But these benefits may come at a cost, the cost being increased risk to financial market stability," the paper underscores.

To highlight these concerns, the paper delves into the recent history of structured finance markets. It says that in the early 2000s, developments in these markets, which were undergoing rapid product innovation, were viewed positively by market commentators: they promised to spread the risk-bearing capacity away from banks to the broader investor community, suggesting lower borrowing costs for firms and individuals.

In the early stages, plain vanilla-type structured products, which packaged physical assets in special purpose vehicles and then tranched and redistributed their cash flow proceeds to investors, were popular. Subsequently, as demand for them grew, a lack of liquidity and supply of the underlying assets that delivered the returns investors targeted, led to the structuring of synthetic products backed by credit default swaps.

"But a lack of transparency on the underlying assets backing many structured products combined with the complexity of certain structures made risk assessment of these products difficult... Despite the over-collateralisation enforced by credit agencies when rating these products, embedded leverage and market risks were materially higher than those modelled. As the un-modelled market and liquidity risks of these products materialised, it led to fire sales that subsequently triggered a broad-based de-leveraging process in the financial markets."

Drawing on this experience, the paper says that there are a number of channels through which risks to financial stability could materialise from ETFs, especially when product complexity and synthetic replication schemes grow in usage.

They include: (1) co-mingling tracking error risk with the trading book risk by the swap counter-party could compromise risk management; (2) collateral risk triggering a run on ETFs in periods of heightened counter-party risk; (3) materialisation of funding liquidity risk when there are sudden and large investor withdrawals; and (4) increased product complexity and options on ETFs undermining risk monitoring capacity.

Synthetic replication schemes deliver ETF investors the index return less a fee charged by the swap counter-party for the total return swap. Replicating returns of broad market indices is, however, not the core business of investment banking. There is also little transparency on how swap counter-parties replicate the index returns to meet their contractual commitment to deliver the total return on the index, the paper says.

It is likely that they use similar techniques to those applied by other ETF sponsors employing physical replication schemes. Such schemes generally hold an optimised subset of the securities in the index basket, and then transfer the risk that the replication basket underperforms the index to the investors. Synthetic replication schemes, by contrast, transfer the underperformance risk to the swap counter-party.

"Within investment banking, the risk 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," the paper warns. "Moreover, 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."

The paper notes that hedge funds often manage the liquidity risk through techniques such as "gating", i. e., by restricting investor withdrawals when market liquidity conditions are poor. "There is no such mechanism in existing ETF synthetic replication schemes to manage liquidity risk when faced with large investor redemptions."

Concerns about counter-party risk can be another channel for risk propagation. Patterns of withdrawal from money market funds during the crisis show that institutional investors are likely to be the first to run when markets question the solvency of a fund provider, which can then trigger a broader run on the industry. Crisis experience has also shown that the collateral assets pledged by a failed swap counter-party could be frozen by a bankruptcy administrator even when they are held in client accounts.

According to the paper, even if the collateral assets can be acquired, there could be industry incentives to progressively shift collateral pools over time to include illiquid assets. This, in combination with the fact that there is very little overlap between assets in the collateral basket and the index basket, might induce institutional investors to liquidate ETFs that are replicated synthetically in periods of heightened counter-party risk.

"Sudden and large investor withdrawals triggered by market events or counter-party risk concerns can also lead to funding liquidity risk. 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."

Finally, says the paper, by employing a variety of markets and players to replicate their benchmark indices, ETFs complicate risk assessment of the end product sold to investors. There is little transparency and no investor monitoring of the index replication process when this function is taken over by the swap counter-party. Financial innovation has added further layers of complexity through leveraged products and options on ETFs.

Again, crisis 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 paper concludes.

[In the post at the "Naked Capitalism" blog, Yves Smith has pointed out that surprisingly little note has been paid to the discussion of ETFs in the reports issued last week by the international regulatory heavyweights, namely, the IMF, the BIS, and the G20 Financial Stability Board.

[The reports, she underscores, show that the authorities are worried. The BIS report, for instance, has an unflattering comparison on its first page, noting that ETFs seem to be serving the same function for institutional investors now as structured credit products did in 2002-2003, with dealers pushing the envelope as far as "innovation" is concerned. The Financial Stability Board was more straightforward, flagging its concerns that ETFs could pose a threat to stability in its report title, she said.

["The regulators discussed the fact that ‘ETF' no longer stands for a single product. Most investors probably assume that an ETF is more or less a mutual fund, when in fact Eurobank affiliated groups' products are typically synthetic (that is, they use derivatives rather than securities. There are even more structural variants, but we'll stick to these two for the purpose of this post). And too often, the relationship between the ETF and the sponsor is not arm's length," she added.

[The post has also cited the overview of Paul Amery at Index Universe, for the view of the FSB paper's authors that: "Securities lending... may create similar counterparty and collateral risks to [those incurred by] synthetic ETFs. In addition, securities lending 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."

[The post by Yves Smith also cites the IMF as warning that: "Bankruptcy laws surrounding counterparty defaults and the potential freezing up of collateral at custodial banks remain areas of concern for ETFs involved in TRS [total return swap] and securities lending. In a variation of the swap-based ETF, the provider sometimes transfers all the cash from investors to the TRS counterparty, which in turn pledges collateral to the ETF's account at the fund's custodian bank. In such a scenario, if the swap counterparty were to default, it could potentially lead the bankruptcy administrator to freeze all ETF assets, preventing the ETF from liquidating its assets if the need arises. Also, the TRS counterparty has an incentive to provide lower-quality collateral in such an exchange, leaving the ETF provider with potentially illiquid assets to offload in the case of a default of the counterparty."] +