Do ETFs Pose a Systemic Risk? Searching for Alpha for July 2011

Exchange traded funds (ETFs) are a near constant in the press. Their low expenses, tax efficiency and ease of use make them the go-to investment for many investors and advisors on behalf of their clients. Lately, however, the attention has become decidedly less positive, as some market watchers and analysts are claiming that these instruments pose a systemic threat to the world’s financial system.

Most of the research performed on this subject has come from Europe, such as a paper by the Bank for International Settlements. Their concerns are predicated on the fact that about two-thirds of Europe’s ETFs use over-the-counter derivatives to gain access to the returns of certain assets classes.  In most cases, swaps are used.

For example, suppose an ETF wanted to replicate the performance of an illiquid asset class, such as junk bonds. Instead of buying the actual bonds and dealing with transactions issues and thin markets, the ETF provider enters into an agreement with a bank to swap the returns of their chosen high-yield index for some fee over LIBOR (the bank can buy the bonds themselves, so that they have no market risk). This type of scheme works fine until there is a liquidity squeeze.  In that case, investors could theoretically be caught in their investment, with no way to monetize.

Collateral and Liquidity

Ultimately, the severity of the issue comes down to collateral. Although mortgage-backed collateralized debt obligations (CDOs) completely collapsed in 2008, there was minimal collateral in these structures, and the underlying assets were of much poorer quality than anything currently offered in ETF form.  Conversely, ETFs are typically 90% collateralized and heavily regulated.