The BoE outs Europe’s synthetic ETF exposure

Posted by Izabella Kaminska on Jun 24 17:04.

There was a sprinkling of ETF talk in the Bank of England’s latest Financial Stability Report out on Friday — much of it warning about synthetic products, echoing concerns flagged by other regulators this year and by the Bank itself in 2010.

But there a few new points being made too — among them the role of European banks in the industry.

Take the following paragraph, for example:

…structure and complexity…

Financial instrument structures can also amplify and propagate stress across markets, as discussed in Box 1. A current example is the rapid growth in exchange-traded funds (ETFs), which have been characterised by increasing complexity, opacity and interconnectedness. ETFs can give rise to risks that may not be transparent to end-investors, making it harder for them to understand and manage their exposures. Where the main investors in complex products have short investment horizons and are leveraged, such as banks, there is greater potential for destabilising fire sales. According to market contacts, banks are not currently in the ETF market as outright investors. Global banks remain exposed to the ETF market, however, through their roles as swap counterparties, securities lenders and market makers. ‘Synthetic’ ETFs, where investors’ cash is entered in a structured derivative transaction with a counterparty — typically an affiliated bank — create further links between the banking system and the ETF market. While market intelligence suggests the synthetic ETF market is concentrated around a few large banks, UK banks are not significant players in this market at present.

Furthermore, it’s the European banks that have been taking advantage of ETF structures for funding puproses in particular, says the BoE:

Competition for funds, and the need to build larger buffers to meet tighter liquidity regulations, has encouraged banks to expore more innovative funding arrangements. These instruments have the potential to create new dependencies and risks in financial markets. For example, a few LCFIs have used synthetic ETFs as a source of funding for less liquid parts of their balance sheet. This form of funding is presently not important for UK banks, but is a sizable source of funding for a small number of euro-area banks.

Naming names isn’t nice, but the big French and German banks come to mind instantaneously. Though, it’s worth pointing out the Bank seems to have omitted the activities of one rather large UK-based lender. One that sold its ETF business quite prominently a couple of years ago, and which replaced it with a renewed focus on exchange-traded notes. These notes offer a much clearer ‘Path’ (ahem) towards funding sources than a pure exchange-traded fund structure. (Yes, we’re talking about Barclays Capital.)

So, what next for such innovative funding tools?

If the latest comments from Hector Sants, CEO of the UK Financial Services Authority, are anything to go by, it’s keeping retail investors out of the products.

As Paul Amery of IndexUniverse notes, Sants said on Friday there were grounds to question whether synthetic ETFs are appropriate for ETF investors:

However, added Sants, any new rules concerning the retail distribution of ETFs would have to be coordinated at a European level. “Most of the banks involved in the European ETF market are located outside our [the FSA’s] immediate regulatory net,” explained Sants. “The right transmission mechanism for us to monitor the ETF market is via the European Securities and Markets Authority (ESMA), the new body responsible for the security of the financial system. We will indeed be pushing proposals through the ESMA process that the rules should be tightened, particularly when it comes to synthetic ETFs, which are our principal focus.”

There were also signs that the UK was preparing to get a whole lot tougher on the industry generally.

As Amery reported:

Adair Turner, FSA chairman and the regulator’s other member (with Sants) on the eleven-person FPC, which will also include five staff from the Bank of England, three external members and the future chief executive of the UK’s new Financial Conduct Authority, Michael Wheatley, explained his institution’s current thinking and why it believes new restrictions on the ETF market may be necessary. “It’s important to understand that, when it comes to ETFs, there are two broad issues we’re considering,” said Turner. “One relates to financial conduct and consumer protection—in other words, do investors in these funds adequately understand the risks—but there are also prudential risks; those risks, in other words, that are created for the banks involved in this market.”

Of course, while they’re at it, they might also want to look at the connection between ETFs, high frequency trading, Delta One, settlement fails, flash crashes and the evolving business of collateral more generally.

Just saying.

Related links:
Do banks see ETFs as inexpensive funding for illiquid securities? – Part I – FT Alphaville
Do banks see ETFs as inexpensive funding for illiquid securities? – Part II – FT Alphaville
How ETFs fueled high frequency trading
– FT Alphaville
Equity shorts in disguise
– FT Alphaville
If we build it, they will come – FT Alphaville

This entry was posted by Izabella Kaminska on Friday, June 24th, 2011 at 17:04 and is filed under Capital markets. Tagged with , , .

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