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UK’s Super-regulator on Systemic Risk and ETFs

Written by Richard Reid  

Date: 24 June 2011

In the first Financial Stability Report (FSR) to be produced under the auspices of the UK’s new super-regulatory body, the Financial Policy Committee (FPC), the risk to stability from Euro area sovereign credit concerns are, perhaps not surprisingly, very much highlighted. No doubt keen to avoid omitting any elements of other risks to stability, the FPC urges the UK Financial Services Authority (FSA) to extend the monitoring of such risks beyond institutions covered by the European Banking Authority (EBA)’s stress tests. It also underlines the need to look at provisioning practices on a wide basis, examine opaque funding structures, issues related to the transition to Basel III capital and liquidity proposals, and the monitoring of banks’ policy on retained earnings (to support the above aims). There is a lot of good material on banks costs of funding and return on equity. It seems the FPC is giving the FSA plenty of work to do.

The Report also takes a look at another issue which the FSA has been commenting on recently: the implications of complexity and innovation in parts of the financial system and, in particular, the potential systemic risks emanating from Exchange Traded Funds (ETFs). Questions of size, interconnectedness and complexity all strike at the heart of systemically important financial intermediaries. Just how much “sifi-ness” there is for a particular institution is of course the subject of a very active debate. The UK is not alone in thinking about this, and indeed this FSR mentions other studies by the FSB, the BIS, and the IMF. The latest edition of the Economist magazine also takes a look at this topic. These funds have shown a remarkable growth in the last three years, especially for the so-called synthetic ETFs (see graph below).

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. 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.

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, it seems there are even some in the industry voicing concerns, 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. 

Value of European ETF market 

Source: Bank of England, Financial Stability Report, June 2011, Section 4, (original source Blackrock)