Earlier this week, FedFin sent clients an assessment of a consultative paper issued without fanfare by the Financial Stability Board on exchange-traded funds (ETFs). It’s noteworthy not just to ETF fans – growing by forty percent a year – but also to anyone contemplating the sweep of systemic regulation over not just institutions, but also product lines seemingly outside the sway of bank regulation. The FSB hasn’t quite figured out what it wants to do with ETFs, but odds are that the current inquiry will lead to top-down regulation. What these rules are will mean a lot to ETFs, but they are also an early warning that success in the financial markets now doesn’t come free. The better a new product does, the more quickly it comes under the systemic gun.
Is this bad? Not on its face. We are all the poorer for seemingly innocuous products that morphed into monstrous complexities with unanticipated destructive force. Think how namby-pamby collateralized debt obligations were before they turned into CDO-squared and, then, synthetic CDO-squared and leveraged CDOs with logarhythmic numbers backed by clueless AAA ratings derived from even more susceptible monoline bond insurers. CDOs started fine, but didn’t end at all well.
Will ETFs follow CDOs into ignominy? That’s of course the question on which the FSB seeks views. Ours is that ETFs can be kept on the right side if the industry now in honest with itself about some of the emerging risks increasingly troubling global regulators. None of these is beyond cure. Indeed, a reasonable cure now could well prevent a downward spiral of yield-seeking financial engineering that eventually blows ETFs – good ones along with the bad – into systemic smithereens.
What are the riskiest aspects of ETFs? First, as with other complex products, these derive from potential conflicts of interest. If the adviser is on all sides of the ETF – structuring and sales, to simplify them – it’s all too easy to stuff an ETF with assets that advantage it at least as much as the investor. Think about how CDOs were structured and the pieces firms like Goldman Sachs kept for themselves as a lesson on how to do this. ETFs as currently offered aren’t easily amenable to conflicts, but tangled incentives are possible when banks are not only selling the ETFs, but also constructing them through securities lending and other programs. The good side of this is efficiency, the bad side is conflict. The quicker these are honestly addressed, the better for the fundamental business – for banks, as well as investors.
The second issue is synthetic – that is, the degree to which ETFs are figments of the issuer’s imagination, based on derivatives designed to mimic the assets held in the fund. So far, synthetic ETFs are only an EU invention, but they’ve grown to about half of that market’s ETFs in no time flat. The SEC last year decided to take its time authorizing synthetic ETFs in the U.S. and, if guided by the FSB (as it will be), these funds may be a long time coming over here.
Is it wise to shutter synthetic ETFs in hopes of nipping systemic risk in the bud? The answer is, we think, a firm “no, but.” Synthetic ETFs can be safely structured, especially for sophisticated investors because of all the new rules established in the U.S. financial market: for starters, OTC derivatives regulation, as well as that now rewriting at least some of the rules governing the ratings agencies. All of these are intended to put derivatives markets on a far sounder footing than they were when products like CDOs went amiss and AAA blessing ran-amuck. Structures are also a darn sight harder to find (and a good thing too, of course). If regulators have confidence in these rules, then they should let ETFs innovate under their aegis. If they don’t trust the new rules, then ETFs are the least of our problems.