Another disaster waiting to happen.

I was never particularly interested in derivatives or ETFs.  Now I know why.

ETFs have potential to become the next toxic scandal
by Tom Stevenson – Telegraph 

Who says regulators are only good for slamming the barn door after the horse has bolted?

Back in April, the Financial Stability Board (FSB), an international super-regulator, wrote a prescient if less than catchily-titled paper “Potential financial stability issues arising from recent trends in Exchange Traded Funds (ETFs)”.

Its central warning – that ETFs are not the cheap and transparent vehicles the marketers would have us believe – was spot on. When UBS's $2bn black hole hit the screens on Thursday, no one who read the FSB report was surprised to see the words ETF and rogue trader in the same sentence.

The past ten years have seen an explosion in the popularity of ETFs. In part this reflects some of their acknowledged benefits – relatively low costs and the ability for investors to trade them throughout the day. A third claim, that ETFs are simple products, may once have been true but it no longer holds water. Many of these funds are now fiendishly complicated and way beyond the comprehension of the individual investors and professionals alike who are buying them.

Here are just a few of the reasons why ETFs are not all they are cracked up to be.

First, around half of the ETFs in Europe today do not match the index they are designed to track by holding all of its constituent shares. Unlike the plain vanilla “full replication” ETFs which do, 45pc of the market is in the form of so-called “swap-based” ETFs which instead use derivative agreements, often with investment banks, to simulate the performance of the underlying assets.

Derivative trades add a second layer of uncertainty to the unavoidable ups and downs of the market, the counterparty risk that the organisation on the other side of the contract might go bust. Even worse, the provider of the ETF might sometimes be a part of the same organisation as the derivatives desk carrying out the swap.

When a bank acts in this dual capacity, and because of inadequate disclosure rules, there is a significant potential for a conflict of interest in which the end investor comes off second best. Because there is currently no obligation for the basket of assets used as collateral to actually match the assets the ETF purports to be tracking, a bank may choose to hold less liquid assets to back the fund which it could struggle to sell if too many investors want out at the same time.

The problem of liquidity is an increasing issue with ETFs because of the way in which the funds have branched out into other asset classes such as fixed income and commodities. In these markets, liquidity is typically thinner than in big equity markets such as those measured by the S&P 500 or FTSE 100.

Liquidity is only ever a problem at times of market stress. Unfortunately, that is precisely the time when it matters, as investors in some real-estate unit trusts discovered a few years back when the property market turned down and, funnily enough, their managers were unable to sell enough properties to pay back redeeming unit holders. Investors were locked in.

A big unrecognised risk with ETFs is related to the ease with which traders – hedge funds in particular – are able to use the funds to short markets. For reasons which I'm not sure I could explain even if I had the space, it is possible for the number of shares sold short in an ETF to massively exceed the actual number of shares available. It has been suggested that the “Flash Crash” of May 2010, in which US shares fell 1,000 points before bouncing back in a matter of minutes, was a consequence of this – around 70pc of cancelled trades at the time were reported to be for ETFs.

Like many financial innovations – most obviously, the alphabet soup of mortgage-related debt obligations that triggered the financial crisis – ETFs started out as a good idea, and for some investors, in their most transparent form, they remain so. But, as so often in the financial services industry, a tangled web of complexity has rapidly developed. 

What was once a straight-forward means of gaining access to a market has turned into a minefield for investors and one which, as UBS discovered in the middle of the night last week, has the potential to become the next toxic scandal.

Three Reasons People Think ETFs Are The New CDOs
by Courtney Comstock – Business Insider 

The Financial Stability Board wrote a report in April this year saying that ETFs might present new, unexpected risks to financial stability.

The full report is available for download by clicking here.

Essentially, the report says that regulators should watch these relatively new products because they can be molded into just about anything, and they're hot thanks to the extended period of low interest rates, which is pushing investors to create leverage in new areas.

And because they're dangerous.

The board found that three things about ETFs pose potential risks to financial stability:

  • The provider might might face difficulties liquidating the collateral and may be faced with the difficult choice of either suspending redemptions or maintaining them and facing a liquidity shortfall and the bank level. The expectation of on-demand liquidity may create the conditions for acute redemption pressures on certain types of ETFs in situations of market stress, which could in turn affect the liquidity of the large asset managers and banks active in this market.

  • A bank default could result in contagion. Since the swap counterparty is typically the bank also acting as ETF provider, or a group of banks acting as counterparties, investors may be exposed if the bank defaults. Therefore, problems at those banks that are most active in swap-based ETFs may constitute a powerful source of contagion and systemic risk.

  • ETFs might create risks for market liquidity. In the event of a market sell-off or an unwind in any particular ETF, there is a risk that investors massively demand redemption. Were redemptions to be made in cash, this could raise issues as to the exit strategies and liquidity risk of ETF providers and swap counterparties. 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 FSB brings up these risks in part because the ETF market has boomed recently. The boom can in part be traced to the current period of protracted low interest rates, which provides incentives for re-leveraging in non-standard market segments.

Whatever the reason, the industry grew at an average of 40% year over year over the past 10 years, says the report. And while most of that growth has been in “plain vanilla” ETFs (like the one that tracks the S&P 500 for example), that are backed by physical assets, in Europe much of that growth has been in “synthetic” ETFs that are created by entering into an asset swap (ie an OTC derivative), with a counterparty*. They up make much more of the ETF market in Europe, reaching 45% of that market.

And ETFs are an area where innovation is booming too. ETFs have branched out to other asset classes (fixed-income, credit, emerging markets, commodities) where liquidity is typically thinner and transparency lower.

Given their recent boom, their underlying assets (or lack thereof), and the relatively little that is understood about the risks they might pose, might ETFs be the new CDOs? The FT's Gillian Tett talked about this back in May. 

She wrote:

The central problem is that the ETF sector – just like those “boring” CDOs five years ago – is currently in the grip of a wave of investor enthusiasm that risks turning a fundamentally sensible innovation bad… And some ETFs are now using leverage; others are starting to purchase riskier assets such as risky loans… And precisely because the market has exploded with such stunning speed, it may be changing flows in unpredictable ways.

Of course there are reasons to take all this with a grain of salt. For example: At the end of Q3 2010, the global ETF industry had $1.2 trillion in assets under management, which is tiny compared to the hedge fund industry, for example. And the new products (leveraged ETFs, inverse ETFs and leveraged-inverse ETFs) only represented 3% of the total ETF market in 2010.

But now we have two instances where “rogue traders” lost billions for their firms trading (or falsely accounting for trading) ETFs.

Of course it was allegedly made via fraudulent accounting and not any flaws inherent in the ETFs. But for products that are supposedly so transparent, some surprisingly large losses have resulted from a couple of back office employees trading them.

Don't miss: Synthetic equity: a way to buy stocks without actually buying stocks

* The provider (typically a bank's asset management arm) sells ETF shares to investors in exchange for cash, which is then invested in a collateral basket, the return of which is swapped by the derivatives desk of the same bank for the return of an index.

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