The Bank for International Settlements has released a working paper by Srichander Ramaswamy titled Market structures and systemic risks of exchange-traded funds:
Crisis experience has shown that as the financial intermediation chain lengthens, it becomes complicated to assess the risks of financial products due to a lack of transparency as to how risks are managed at different levels of the intermediation chain. Exchange-traded funds, which have become popular among investors seeking exposure to a diversified portfolio of assets, share this characteristic, especially when their returns are replicated using derivative products. As the volume of such products grows, such replication strategies can lead to a build-up of systemic risks in the financial system. This article examines the operational frameworks of exchange-traded funds and identifies potential channels through which risks to financial stability can materialise.
The part I found most interesting was:
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.2 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 (Russell Investments (2009)).
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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 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,7 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.
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Synthetic replication schemes, by contrast, transfer the underperformance risk to the swap counterparty. 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. 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. Hedge funds often manage the liquidity risk through techniques such as “gating”, ie by restricting investor withdrawals
In Canada, there is the Horizons S&P/TSX 60™ Index ETF (HXT) that operates in this way. There may be others.
This may be just another instance of the regulators not thinking things through. Yes, the swap transaction may have a term of greater than one year. But if investors can redeem at any time, then it’s just another wholesale demand deposit, and should be treated accordingly.
[…] attention was immediately caught by the fact that BIS concerns regarding synthetic ETFs have been given a prominent place in the threat list. Box 1 (on pages 16-17 of the PDF) points out […]
[…] small to absorb the pension funds that are dependent upon it is interesting. There is at least one article in the Interesting External Papers category of PrefBlog that shows the regulators have been very worried in the past about what I call ‘liquidity […]