IMF echoes ETF concerns

From Global Pensions:

The International Monetary Fund has become the latest financial body to express concerns about the growth of the ETF industry.

The IMF's warnings, made in its latest Global Financial Stability paper, centred on the risks involved with synthetic replication and securities lending. They echo similar concerns expressed recently by the Financial Stability Board and the FSA.

The report acknowledges these "enhancements" reduce costs, but increase counterparty and liquidity risks. ETFs are as yet a relatively small market in Europe in comparison with the US. However, despite this there are strong signs that pension funds, hedge funds and other investors are beginning to embrace these products.(Global Pensions: 08 December 2010)

Part of the IMF's unease stems from the growing size of the synthetic ETF market in Europe, which it argues increases the potential for contagion.

The report says: "The gross exposures of these funds raises some concerns on whether current restrictions on derivative contracts are sufficient to curtail counterparty risks from becoming systemic under stressed market conditions."

The IMF also alleges that investors are unhappy with current regulation that requires ETF providers to be able to recall lent securities and provide collateralisation.

It reveals: "Participants claim this process currently lacks transparency and that the cash reinvestment guidelines have not been clearly laid out by regulators."

The report also calls into question the ability of ETF issuers to maintain normal creation and redemption mechanisms at times of market stress, and reiterates concerns that heavy ETF trading could disrupt prices in small markets and commodities.

Sovereign Investor:   Exchange Traded Funds (ETF) are used by transition managers, amongst others, to obtain market exposure as part of a cost-efficient transition strategy.  In light of regulator and IMF concerns, is this approach wise?  What is your experience?  The IMF paper (10.50 MB) can be downloaded here.  Annex 1.7 (page 69) is the place to find a useful discussion on ETFs.  The introduction to the Annex reads,

Exchange-traded funds (ETFs) have become increasingly popular over the past few years.  They give investors increased access to emerging market assets while also offering flexibility and leverage to specialized investors. Traditionally, ETFs have physically held underlying assets, but a new breed of ETFs have emerged in Europe that use synthetic replication techniques and derivatives to reduce costs and thereby boost returns.  A small percentage of these funds also use leverage to cater to the hedging needs and speculative positions of their nonretail client base. While these enhancements have reduced costs, they add a layer of complexity and increase counterparty and liquidity risks. The disproportionately large size of some ETFs compared with the market capitalization of the underlying reference indices poses a risk of disruptions in some markets from heavy ETF trading. This annex surveys the growth and mechanics of ETFs and highlights some of the key risks pertaining to synthetic replication and the use of leverage and derivatives in ETFs.

Complexity?  The following diagram from the report provides some hints

 Risk?  The report describes the following menu, for those so inclined:

• Counterparty and mark-to-market risk for the ETF provider
• Leverage risk for investors
• Liquidity risk
• Market disruptions
• Legal and policy risks