The International Centre for Financial Regulation (ICFR) says further assessment of the potential risks from ETFs needs to be considered.
The International Centre for Financial Regulation (ICFR) has highlighted the need to further assess the potential systemic risks emanating from Exchange Traded Funds (ETFs). The first Financial Stability Report (FSR) to be produced by the UK's new super-regulatory body, the Financial Policy Committee (FPC) covers the issue of ETFs, which have shown a remarkable growth in the last three years. As the report notes, ETFs started off around 1990 by using investors' cash to purchase the basket of securities comprising the index from the market - the "physical" replication. These are typically simple products but may be exposed to counterparty risk. They may also have limited disclosure of lending practices.
However, it is in the area of synthetic ETFs that the ICFR is calling for action. Richard Reid, director of research at the ICFR explains that, in contrast to physical ETFs, synthetic ETFs do not purchase the index securities outright, but gain exposure by entering into derivatives contracts with a counterparty (typically an affiliated bank). "These synthetic ETFs are therefore much more complex and may also represent liquidity risks to bank funding. They raise memories of the subprime crisis, packaging of mortgage bonds and a basically good idea turning into a poorly understood and monitored innovation," says Reid.
Reid believes it is probably early enough in the growth of these funds to be able to
say that they do not represent a true systemic risk. However, he points out that the level of concern is rising, particularly about the number of new vehicles. "Regulators, conscious of the pressure they are under to consider ways of heading off systemic risks to financial stability, will be keen to think about what steps they should be taking now to supervise this market segment. The emphasis at present, as today's report states, seems to be on better characterisation and disclosure needs, as well as collateral and liquidity management," says Reid.
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