Financial Stability Board Must Provide More Details on ETF-Risks

The Swiss-based FSB (Financial Stability Board) has released a report on potential financial stability issues arising from recent trends in ETFs. But this report does not provide the necessary depth and details to be useful. A comment by MyPrivateBanking ETF specialist and author Francis Groves.

The FSB seems to be taking aim primarily at swap-based (or synthetic) ETFs and, in particular, at the possibility of mis-matches between asset being tracked and the collateral being provided by the swap counterparty, not in terms of a discrepancy in value of the two but in terms of their liquidity. The FSB note uses the example of an S&P 500 ETF where the swap party collateral is made up of illiquid equities or junk bonds. The possible nightmare scenario in this case would be a run on the US equity markets and massive redemption orders in the ETF’s primary market.

The first point to bear in mind is that the danger arises if the a fall in the S&P 500 is what might be called symptomatic – the scenario envisages a universal crash. In that case the assets in the collateral basket would be under even greater pressure than the S&P 500 just because they’re less liquid. However, in situations where particular conditions were putting just US stocks under pressure, the ETF could become over-collateralised – more value in the collateral than in the asset the ETF tracks.

The FSB note is too short to go into detail about all the possible outcomes. One possible outcome that it does specify is the ETF sponsor having to call a halt to redemptions of ETF shares. It’s not clear how catastrophic that would be. Presumably, the institutions that weren’t being allowed to make redemptions could still sell their ETF shares in the secondary market. With swap-based ETFs creations and redemptions don’t play the crucial role of keeping the ETF’s price in sync with the assets tracked that they do with in-kind replication ETFs.

Presumably, an ETF sponsor could run into problems that were just as serious, if the collateral was too concentrated in one particular asset and that asset’s price was going in the opposite direction (ie. down) to the price of the assets tracked by the ETF. Whether or not the collateral asset was liquid, the ETF could have to make up a lot of collateral all of a sudden or be in danger of losing it UCITS lll-compliant status.

Of course, there must be plenty of ETFs where the contents of the collateral basket are more liquid than the asset the ETF is tracking. However, although these liquidity differentials balance out overall, it’s also true that they only have to be out of balance in one area of the ETF market (ie. for a series of ETFs tracking one important asset class) for serious problems to arise (potentially). So, although the FSB seem to be exaggerating the danger somewhat, there is a good case for ETF sponsors being candid about the collateral that’s being used for swap-based ETFs and having a sense of responsibility about what’s appropriate in terms of liquid-ness.

In this connection, when iShares began to sponsor UK-listed swap-based ETFs in the latter part of 2010, they seem to have been fully upfront about the collateral. A tab appeared alongside the “Holdings” tab with the top 10 collateral holdings, the full list, the swap counterparties and the sector allocation. So for the iShares MSCI Russia Capped Swap ETF, one can see that the fund is (for yesterday) 11% over-collateralised and that, whereas the MSCI Russia capped index has a concentration of about 73% in energy and materials, the collateral is only weighted to 8.5% in ‘extractive industries’.

One final point; the FSB seems to be pinpointing those sponsors who act as their own exclusive swap counterparties as being particularly at risk but, surely, if the ETF is big and only has one or two swap counterparties, the risks are just the same.

Francis studied at the London School of Economics. He has many years of experience in the field of online business information, having worked for Reuters, the Financial Times and LexisNexis. He is the author of 'Corporate Actions, A Concise Guide' (2008) and the recently published 'Exchange Traded Funds, A Concise Guide to ETFs'. His blog is ETFSTall.