Although exchange traded fund (ETF) trading is unlikely to threaten financial stability, OTC derivatives and securities lending operations do have relevance for systemic risk assessment, says research.

In terms of exchange traded funds (ETFs), systemic risk refers to the possibility of an ETF-specific crisis spilling over to the wider financial system. A few key concerns have been voiced. One is based on the assumption that parties to collateralised transactions post hard-to-fund illiquid assets as collateral and that massive ETF redemptions could cause a funding liquidity shock to these swap or securities lending counterparties (FSB, 2011 and BIS, 2011a).

Another concern centres on whether the collateral composition could trigger a run on ETFs in periods of heightened counterparty risk (BIS, 2011a); the idea that large-scale ETF redemptions could create a squeeze on the underlying market as ETFs recall on-loan securities (FSB, 2011).

The idea that increased complexity might result in an overestimation of market liquidity by investors and that subsequent downward revisions could wreak havoc on the financial system (BIS, 2011a) is also a point being discussed.

Because index replication is not the core business of investment banking, swap counterparties co-mingle “tracking error risk with the trading book risk” in a way that “could compromise risk management” (BIS, 2011a). This is another idea that is being discussed. The idea that the use of ETFs as collateral in “a chain of securities lending and rehypothecation may create operational risks and contribute to the build-up of leverage” (FSB, 2011).

These concerns, some of which have been presented, are most often vague, highly tentative and hardly ever based on facts. With respect to the possible overestimation of the liquidity of ETFs, the true liquidity of an ETF ultimately depends on the liquidity of the underlying. This research is not aware of stumbling blocks that would prevent the industry from providing the competent authorities with the disclosures it would require for monitoring the risks it is concerned about.

As to the suggestion that investment banks cannot properly hedge swaps on indexes, this is downright puzzling and would need to be substantiated.

With respect to the use of shares in ETFs as collateral and their possible rehypothecation, we understand the mention arises because the practice is not possible with units of mutual funds but feel this question should be addressed in the wider context of the regulation of securities lending.

When discussing the systemic importance of the ETF industry, it is useful to compare its size to that of the overall fund management industry and to that of the markets for over-the-counter derivatives and securities lending.

In Europe the AUM of ETFs represented 2.7% of the overall fund management industry at the end of the first half of 2011. Only 3% of these belonged to leveraged and inverse ETFs. So this segment represented less than 0.1% of the overall fund management industry in Europe¹.

A similar picture arises from the comparison of the AUM of synthetic ETFs with the size of the swap markets. According to Bank for International Settlements (BIS) (2011b) data, the notional amount of equity-linked OTC derivatives outstanding at the end of the first half of 2011 was $6,841 billion, about the same as the volume outstanding on exchanges ($6,426 billion), and almost 1% of the overall OTC derivatives market.

The outstanding notional on OTC futures and swaps was $2,029 billion. Assets under management (AUM) by synthetic and hybrid replication ETFs then totalled $191.1 billion across all asset classes². For example, 9.4% of the outstanding notional amount of equity OTC futures and swaps and 2.8% (1.4%) of the outstanding volume of OTC (and exchange-listed) equity ­derivatives³.

According to Data Explorers, there is currently $1.8 trillion worth of global securities on loan, including $734 billion of equities (Hampson, 2011). At the end of September 2011, global ETFs had $41 billion on loan across all asset classes. However, there was little going on ($2.5 billion) outside of the US, with European ETFs lending only $1.9 billion worth of securities (Data Explorers, 2011).

This is to be compared against AUM of $1,245.6 billion in the global ETF industry and $267.4 billion in the European ETF industry. At the end of the third quarter of 2011, ETFs had 3.3% of their assets on loan globally and 0.7% in Europe⁴ and their operations represented 2.3% of the current volume of assets on loan⁵.

Doubtful threat
Given the orders of magnitude of global ETF transactions, it is doubtful that the realisation of risks specific to ETFs could threaten financial stability. This should not be interpreted as meaning that OTC derivatives and securities lending operations do not have relevance for systemic risk assessment. Clearly, these increase the connectedness of financial institutions with one another. Improved disclosure about counterparties and exposures would be useful for modelling systemic risk and assessing it at multiple levels.

This should not be misconstrued either as meaning that the ETF market should benefit from particular exemptions when it comes to systemic surveillance. It is important that risk be assessed across all markets in which institutions deal and that risk accumulation in certain product or economic markets be kept at acceptable levels.

Systemic risk can arise due to exposure to common market risk factors across financial institutions (often referred to as correlation) but also through contagion via counterparty risk or liquidity shocks. Systemic risk involves risk that arises from the structure of the financial system, including the number of institutions, their characteristics (size, health and other characteristics), their degree of homogeneity, their interactions with one another and other factors. So, size matters. However, ruling out the systemic importance of an institution or a market just because of its size would be ­dangerous.

The recent financial crisis has underlined the importance of contagion effects in systemic risk. It has also highlighted the lack of appropriate metrics, both at the system and the institution level such as data to monitor systemic risk and contagion correctly. Efforts by academics, regulators and practitioners to shift from lamenting the uncertainty of the financial system to defining and measuring systemic risk are to be lauded.

The size of an institution is not sufficient to assess its systemic importance. Attention must be paid to its connectedness to other institutions in the context of networks and dealings across all institutions. (For a review of the extant literature, see Upper, 2011 and for new metrics, see Cont, Moussa and Bastos e Santos, 2010.)

While small, the ETF market is highly concentrated. It would make sense to study how the failure of a dominant company would disrupt the market and what the spill over effects would be so as to improve risk mitigation mechanisms if need be.

As things stand, the bulk of the European ETFs is regulated by the European Union’s Ucits directive. The requirements and constraints of Ucits are the same to all Ucits funds, whether listed or not. ETFs are not special entities distinct from other Ucits. They are wrappers for Ucits funds that need to comply with additional listing rules set by exchanges.

When Ucits-regulated funds (including ETFs) use derivatives, they do so within a precise regulatory framework and comply with clear rules which have been approved by market regulators. While securities lending operations do not enjoy the same level of scrutiny, this is not specific to Ucits.

The recent reports on the risks of ETFs, particularly on the topic of systemic risk, contain multiple instances of speculative remarks on liquidity spirals and contagion effects, which are not backed by any theoretical framework or empirical evidence.

Higher standards should be expected from international and domestic regulators. Any discussion on the systemic risks posed by ETFs should have a sound theoretical base and be backed with empirical evidence.

As to the impact of ETFs on their underlying markets, there is a large body of academic research that exists. The question of the impact of securities lending has also received attention.

Beneficial role
Multiple studies have documented the beneficial role of securities lending on market liquidity, cost of trading and price efficiency. Securities lending facilitates market-making, trade settlement and short-selling.

The bulk of the studies on the theoretical impact of short-selling concludes that restrictions on short-selling negatively impact the underlying market either by restricting the participation of optimists (see inter alia Miller, 1977) or decreasing the informational content in stock prices (see Diamond and Verrecchia, 1987; Chen, Hong and Stein, 2002; Bai, Chang and Wang, 2006).

Depending on further hypotheses, this can translate into overpricing followed by reversals (see inter alia Miller, 1977 and Chen, Hong and Stein, 2002 as well as Chen and Stein, 2003 for a link to bubble formation and market crashes) and/or higher volatility (eg. Bai, Chang and Wang, 2006).

Empirically, short-selling is found to improve price efficiency (Bris, Goetzmann and Zhu, 2007; Boehmer, Jones and Zhang, 2008; Boehmer and Wu, 2010). Constraints are found to negatively impact market quality. Inter alia Chen, Hong and Stein (2002), as well as Jones and Lamont (2002), find that high costs of short-selling or restrictions lead to subsequent stock underperformance; Boehmer, Jones, and Zhang (2009) show that short-selling bans imposed after 2008 have degraded the market quality for the stocks affected (spreads, price impacts, and intra-day volatility) and Lioui (2011) links these bans with increased index volatility.

Saffi and Sigurdsson (2011) study 12,600 stocks from 26 countries between 2005 and 2008 and find a negative relationship between short-sale constraints and stock-price efficiency at a stock level all over the world. They observe that equity lending supply is an important driver of differences in price efficiency.

A higher supply reduces occurrences of extreme price increases but is not linked with extreme price decreases. (This is in contrast to the evidence in Bris, Goetzmann and Zhu, 2007, who found that short-selling could potentially facilitate severe price declines.) They also find that a lower supply and higher loan fees are associated with greater downside risk and total volatility.

A recent market experience by Kaplan, Moskowitz and Sensoy (2011) indicates no adverse effects on stock from securities lending. Altogether, there is a strong academic consensus that securities lending improves market efficiency. There is no empirical basis for the view that it could destabilise prices, quite to the contrary.

More specifically on ETFs, a vast body of academic research has looked at their influence on the price efficiency in the index spot futures market. Hasbrouck (2003) and Tse et al (2006) show a clear price leadership of the ETF market over the spot market. This suggests ETFs process information faster than the spot market and contribute to price discovery.

Furthermore, there is evidence (Hegde and McDermott, 2004; Madura and Richie, 2007) from the Diamonds and the QQQ funds suggesting that the liquidity of the underlying index market increased after ETFs were introduced because of a decline in the cost of informed trading. [The QQQ is an ETF that allows investors to invest in all of the stocks that make up the Nasdaq 100 in a single security.]

Deville et al (2009) find the introduction of ETFs indirectly improves spot future price linkage by enhancing the liquidity of the underlying stocks. Ackert and Tian (2001), Kurov and Lasser (2002), Deville (2005), and Deville and Riva (2007) show that the introduction of ETFs significantly improved price efficiency in the index spot futures market.

Recent reports by regulators and international organisations concerned with financial stability have trumped up the systemic risks of ETFs. On closer inspection, the case is woven from broad-brush parallels and dubious assumptions. There is little in the way of a sound theoretical framework, let alone supporting empirical evidence.

The assets controlled by ETFs are but a sliver of the AUM in the fund management industry. They are dwarfed by the capitalisation of listed equity, by the notional amount of equity futures and swaps and their securities lending activities are marginal in comparison to the size of this industry. In this context it is doubtful that risks specific to ETFs could cause major disruptions to these market segments.

US ETFs and European Ucits ETFs are not less regulated than mutual funds and other Ucits. The tools that index-tracking ETFs use to implement their strategies are also available to other funds and products. Therefore, we see no reason to single out these highly regulated vehicles and attach stigma to their activities.

To the extent that securities lending and OTC derivatives transactions, while typically collateralised, increase the connectedness of financial institutions with one another, we believe improved disclosure about counterparties, exposures and risk mitigation would be useful to improve the monitoring of systemic risk. However, we suggest such disclosures be implemented in a horizontal rather than piecemeal way.

With respect to the fears that the development of ETFs may have hurt the underlying markets, we find that a rich theoretical and empirical literature points in the opposite direction.

Noël Amenc, professor of finance, Edhec Business School and director of the Edhec-Risk Institute, and Frédéric Ducoulombier, director of Edhec Risk Institute, Asia, wrote this article.

Footnotes
1 Computed from industry figures provided in BlackRock (2011) and EFAMA (2011).
2 The ETF market is roughly 80% equity-linked.
3 BlackRock (2011), Figure 149.
4 In Europe 41% of the AUM in the ETF industry are managed by providers relying on synthetic or hybrid replication (BlackRock, 2011) and these ,without exception, do not currently engage in securities lending.
5 Computed from statistics provided in BIS (2011b).

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