Industry responses to an European Securities and Markets Authority (ESMA) review of exchange-traded funds (ETFs), have highlighted unanticipated systemic risks.
In a July consultation paper aimed at reviewing the UCITS directive's treatment of ETFs, the watchdog voiced concerns over a perceived lack of transparency and risks associated with the quickly-growing ETF market.
Areas where ESMA believed transparency and disclosure to investors should be improved included better identification of ETFs, issues with how indices are tracked by ETFs, the securities lending activities of ETF manufacturers, and clearer delineation of actively-managed and leveraged ETFs from passive ETFs.
ETFs have been under the spotlight since UBS revealed a £2.3 billion fraud allegedly perpetrated by a rogue trader on UBS's Delta One ETF trading desk earlier this month.
Europe's macro-prudential oversight body, the European Systemic Risk Board (ESRB), expressed reservations over the use of ETFs in high-frequency trading (HFT) and resultant liquidity issues on secondary markets.
“The liquidity provision and price formation processes of ETFs on secondary markets rely particularly on the implementation – most often by algorithmic and high-frequency traders – of liquidity provision and arbitrage strategies,” the ESRB said. “Against the background of ETFs' provision of ”on demand' liquidity to investors and questions about the impact of HFT, concerns are expressed on the capacity of investors to assess truly available liquidity and related liquidity costs.”
The ESRB was particularly worried about the potential risks to ETFs that track illiquid asset markets, such as emerging markets and commodities.
“They may also occur due to specific ETF features, such as the rebalancing of leveraged and inverse ETF positions,” the ESRB said. “Thus, ETFs may be particularly vulnerable to liquidity shocks, and, due to their hybrid nature of stock and fund, particularly likely to transmit such shocks across markets, market segments and asset markets.”
However, the London Stock Exchange (LSE) countered that liquidity issues were not the same in every European market, intimating London could serve as benchmark through its use of official market makers to support listed ETFs. “The fulfilment of market-maker obligations is essential for the provision of liquid, transparent and orderly secondary markets,” the exchange said, adding it monitored market-maker performance against these obligations to ensure they continuously displayed two-way prices within the applicable maximum spread and minimum quote size throughout the trading day.
“In particular market circumstances, market makers can be exempted from the fulfilment of their obligation. In these cases, as well as in case of delisting of the ETF, the right of the investors to request direct redemption of their units from the UCITS ETF should be assured,” the LSE said. “It should also be noted that for ETFs, liquidity is not limited to that provided by registered market makers on-screen, as with other on-exchange instruments (such as standard equity shares) there is substantial off-book as well as on-book liquidity.”
The LSE added that ETFs offered considerably higher levels of on-screen liquidity and transparency than other funds where there was no continuous intra-day pricing.
ESMA itself has highlighted fears over insufficient distinctions between active and passive ETFs. It said while most UCITS ETFs aimed to replicate the performance of an index and were passively managed, actively managed UCITS ETFs often aimed at outperforming an index or benchmark.
Actively-managed UCITS ETFs use the standard structure of an ETF but the manager has discretion in relation to the composition of the portfolio, subject to stated investment objectives and policies. ESMA warned the majority of investors were not aware of the difference between index-tracking ETFs and actively-managed ETFs and their resultant associated risks.
Meanwhile, ETF provider Lyxor Asset Management said international bodies had so far failed to highlight sampling replication as a potential source of risk.
“Sampling replication creates a risk for investors that a UCITS, which is supposed to be indexed, is in fact only benchmarked to the index,” the firm said. “In marked stressed events, it is not impossible that such a replication technique will not work and produce significant tracking errors.”
Lyxor believed investors should be warned of the risks incurred by sampling replication and that there should be some minimum tracking error requirements, as a fund management objective, to allow an ETF to be qualified as an index fund.
“ETFs that use sampling replication with significant tracking error should be qualified as ”actively managed ETFs',” Lyxor said.
Independent exchange-traded products provider, ETF Securities, called on ESMA to break up what it perceived as silos in the ”vertically-integrated' synthetic ETF offerings of large banks.
ETF Securities, which owns a Dublin-domiciled UCITS supermarket, ETF Exchange, asserted that there were potential conflicts in the way banks approached ETFs.
“[If a bank was] the ETF issuer, they should be acting in the best interests of investors. [But if they are also acting as] the swap counterparty – or stock-lending recipient – they will inevitably seek to act in the best interest of the bank [not necessarily the interests of the investor],” ETF Securities said.
The company said vertical silos could give rise to further conflicts of interest detrimental to the investor, including the ETF design stage, operations or – in the extreme – in a liquidation scenario.
“We believe the interests of the ETF investors should be paramount and this cannot be assured in a vertically-integrated model,” said ETF Securities.
A spokesperson for ESMA said the watchdog was presently collating the 51 responses it received and would likely release a second draft of its guidance paper “in a few months' time”.