Industry experts respond to regulators' recent warnings on ETFs
Deborah Fuhr, BlackRock global head of ETF research and implementation strategy
I strongly support the efforts by the Financial Stability Board, the Bank for International Settlements and the International Monetary Fund to increase understanding of ETFs and exchange-traded products, including notes, partnerships, grantor trusts, commodity pools and other non-fund structures.
The move to synthetic ETFs has meant many different models are being offered by various providers. This has changed the understanding and transparency on costs, because the commission and annual financing costs of swaps are not part of synthetic ETFs' annual total expense ratio.
Transparency on the underlying portfolio in some products is no longer daily and the number of brokers who are authorised to create and redeem the swap is typically much lower than physically-backed ETFs.
Greater transparency on trades is also needed. ETF trade reporting is not required for most trades under the markets in financial instruments directive (Mifid). Mifid II should require all ETF trades to be reported and provide for a consolidated tape. This will provide a greater level of price discovery, tighter spreads and give all investors better transparency on the real secondary liquidity in ETFs.
Overall the thrust of these reports points to significant concern around systemic risk posed especially by synthetic ETFs of the ‘in house' model and to a lesser extent securities lending.
Nizam Hamid, Lyxor head of ETF strategy
The main areas of complexity and opacity relate to instruments often confused with ETFs - these are ETNs, ETCs and ETVs. Derivatives regulations are very well detailed and well established in the context of the Ucits directive. There is no such level of EU regulations concerning securities lending by Ucits.
It should also be noted that the physically-owned assets of the ETF are segregated from the bank's assets. The focus on over the counter (OTC) swaps used within ETFs is perhaps an unfair reflection of the size of the market and indeed overly dramatic.
At the end of June 2010, according to the Bank for International Settlements, total forwards and swaps in equity linked derivatives amounted to $1,745bn, whereas the total size of assets under management in swap-based ETFs was only $124bn. All equity-linked exposures at the end of June 2010 totalled $6.3trn so again, as a proportion of this, European ETF swap exposure would be less than 2% of the total.
Therefore we would argue that European ETF swap exposure cannot easily be presented as a source of contagion and systemic risk when compared to the broader swap and OTC market.
Feargal Dempsey, iShares EMEA head of product strategy and Stefan Kaiser, director working in securities lending
Dempsey: The FSB's report acknowledges it is not enough to just talk about transparency and disclosure. Rather, a provider has to go down to the granular detail and show the robustness of its procedures and the frameworks to support them. A number of regulatory bodies have expressed their concerns over ETFs, and the FSB is spelling out some of those. This is an opportunity for providers to answer those questions and show how they addressing the issues.
An ETF is as liquid as the market it represents so if there is not sufficient liquidity in each of the securities in the index then it will have to be screened or, as frequently happens at iShares, we will decide we cannot launch that product. A good provider will prioritise liquidity analysis during product development - we run scenarios looking at both normal trading and adverse trading conditions.
The key thing is that you are able to process redemptions in an orderly fashion. In liquid markets, large redemptions are easily accommodated. There is also provision in fund documentation to pass orders onto the next day if there are more than 10% redemptions in a single day, which allows for an orderly sell-down. This is rarely invoked though, and I think the nature of an ETF means you should not often see these kinds of issues.
Kaiser: Under our securities lending programme the transactions happen overnight, so we can recall it in the normal settlement cycle. If there was ever an issue with getting the stock back - and that is very unlikely to happen - all the costs would accrue to the broker that failed to return the stocks.
It is about best practice. I think the FSB is referring to doing securities lending in a responsible way. You could increase revenue by accepting more risky collateral, or lending to counterparties that have a poorer credit rating, but BlackRock is not about to do that.
Dempsey: We essentially gold-plate Ucits requirements around collateralisation. Additional regulation around disclosure and collateral rules could be helpful; there is nothing to fear and we are all very keen to protect the ETF brand. I tended to focus more on the latter part of the report. I saw it as the FSB asking how we can enhance the ETF brand, rather than looking for a disaster scenario.
A source at a leading swap-based ETP provider:
Inevitably when something grows rapidly there are going to be questions and maybe clarifications required. What I would point out is that some of the issues raised are not just relevant to ETFs, but pertain to the whole fund industry.
When a bank is acting as both issuer and swap-provider, all the fund fiduciary aspects are done by independent parties. The parent bank is an arm's length swap counterpart, so I do not understand why there would be any conflict of interest there. Moreover, the issuance vehicles for the funds are typically umbrella investment companies. These are standalone; they have independent auditors and are subject to audit every year. So I think the FSB has misunderstood that point.
As for the issues of maintaining redemptions, one of the features of the ETF market is that selling takes place on the secondary market, so there are market-makers who can soak up a lot of that. What we normally see during periods of market volatility is that ETF market-makers adjust by slightly widening their spreads, but they are still providing liquidity, so people are able to sell.
If you were in an actively-managed fund and everyone tried to redeem on the same day, you would probably struggle more. What we have actually seen is when there have been volatile situations and heightened activity, such as the end of 2008 and beginning of 2009, the ETF market has adapted very well.
In terms of transparency we are providing over and above what regulations require. We would be happy for it to be put into regulation because we are already doing these things anyway, but I have to ask if we have that level of transparency, why is it not there in actively-managed funds? If regulators are going to impose these kinds of disclosure obligations then it should be a level playing field for the whole fund industry.
ETFs are subject to Ucits, which is the top tier of fund regulation, so investors should take comfort from that and not think of them as unregulated products. Even the new, smaller providers, who may not do all the same things as us in terms of transparency, are still at least conforming with regulation.
It is important for investors to understand there are various forms of exchange traded products (ETPs) which tend to be loosely defined as ‘ETFs'. The ETP industry needs to educate investors and be clearer on the labelling of various ETPs. We are engaging with other ETP providers on this objective in order to have set standard definitions for the European ETP industry.
The FSB appropriately highlights the operational risks associated with the lending of securities in the context of some physically-replicated ETFs.
The quality of collateral held in relation to ETF Securities' ETF range on its ETFX platform is already subject to an eligible collateral schedule which sets out stringent guidelines as to what is acceptable and which are more conservative than the current Ucits requirements.
In the coming weeks, ETFX will be publishing a list of all collateral held independently by Bank of New York Mellon on its website in order to increase transparency to investors.
We support the FSB's view on the conflict of interests and risks associated with in-house products where the swap provider and ETF issuer are all a single part. ETF Securities is an independent product issuer supported by high quality counterparties which are regularly monitored with respect to their credit risk. The ETFX model promotes minimal risk correlation between issuer and swap provider in the event of default.
Michael John Lytle, managing director at Source:
I do not think ETFs are such a large part of the market that they can cause the kinds of disruptions the FSB is talking about. ETF assets in Europe represent just over 3% of all fund assets and trading represents 5% of on-exchange turnover. I do not mean to be unfairly dismissive, but no-one is providing an example that brings this concern to life. I do not know of an ETF where the AUM is meaningful in relation to the market cap of the underlying stocks.
In the last month four major regulatory bodies have come out and commented on ETFs, but this is a market that got big a couple of years ago. We were constantly refining our model through the financial crisis, and I feel that if you have been listening and responding, the marketplace over the last three years has been a pretty good environment to create robust products.
The FSB is saying that however you get market exposure, there are effectively the same potential liquidity issues. Securities lending is basically an upside-down version of synthetic replication: either you get the perfect basket and get paid to lend it or you take an imperfect basket and buy a derivative to cover the difference.
The conflicts of interest come through in relation to physical ETP issuers as well. It is clear that some asset managers are making more money from stock lending than the actual management fee. I read the report as saying there are the same issues in both, and that investors have to look for the agenda behind them.
Most of the assets held in the industry are with issuers who create ETFs as a way of packaging their existing products. Our setup is fundamentally different because we do not have one commercial entity driving our agenda. We put banks in competition for the derivatives, so we are not delivering what a commercial institution wants to sell, but the best deal we can get in the marketplace.
These sorts of discussions happen on a bilateral basis all the time, and I think sophisticated financial institutions are comfortable with the answers. If this draws much larger audiences into those conversations then that is wonderful and positive. If it just leads to alarmism, that is not so good.
David Murtagh, head of ETF trading, Susquehanna:
Broadly speaking, an ETF should trade close to its NAV if the underlying market is liquid. Other factors that will impact on this include the costs associated with processing creations and redemptions. Taxes can be significant here, as well as how many market makers are trading the product.
Competition among multiple market makers means ETFs are likely to trade at a fairer price. If the underlying markets are not all open when an ETF is trading, the tightness of the spreads will depend on how well market makers can hedge their risk. NAV will not necessarily be the fair price for these products, because global markets may have moved since the underlying market closed and these movements have to be taken into account.
If there was a lot of buying and selling pressure in an ETF when the underlying market was closed then market makers will move their markets in an effort to balance their books. Again, the more participants, the less the price is likely to move.
With an ETF whose AUM is large relative to the market cap of the underlying securities, buying or selling pressure in the ETF will impact the price of the underlying securities. An ETF that tracks illiquid and hard to sell securities will itself have similar characteristics. ETFs tracking emerging market bonds, for example, have significantly wider spreads and are less liquid than those tracking German governments.
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