naked capitalism

Surprisingly little note has been paid to the discussion of ETFs in three reports issued last week by international regulatory heavyweights, namely, the IMF, the BIS, and the G20 Financial Stability Board.

Make no mistake: the authorities are worried. The BIS report, for instance, has an unflattering comparison on its first page, noting that now ETFs seem to be serving the same function for institutional investors now as structured credit products did in 2002-2003, with dealers pushing the envelope as far as “innovation” is concerned. The Financial Stability Board was more straightforward, flagging its concerns that ETFs could pose a threat to stability in its report title.

The regulators discussed the fact that “ETF” no longer stands for a single product. Most investors probably assume that an ETF is more or less a mutual fund, when in fact Eurobank affiliated groups’ products are typically synthetic (that is, they use derivatives rather than securities. There are even more structural variants, but we’ll stick to these two for the purpose of this post). And too often, the relationship between the ETF and the sponsor is not arm’s length.

Paul Amery at Index Universe provides an overview:

The focus in the BIS paper on regulatory arbitrage by banks—the use of ETFs as a funding mechanism for parent investment banks, with the maturity of the swap being used to disguise the fact that the bank is effectively receiving overnight funding from the ETF while also obtaining relief from key liquidity metrics for the calculation of bank capital requirements—raises serious questions about the whole business model of synthetic ETF replication.

Mind you, this does not mean that the “physical” ETFs are paragons of virtue either. They merely play close to the wind in another manner, through securities lending (remember how that blew a $20 billion hole in AIG’s balance sheet?). Amery again:

According to the FSB paper’s authors: “Securities lending…may create similar counterparty and collateral risks to [those incurred by] synthetic ETFs. In addition, securities lending could make the liquidity position of the ETF fragile, by challenging the ability of ETF providers to meet unexpected liquidity demands from investors, particularly if outflows from ETFs become significant under severe stress. A prevalence of securities lending could create a risk of a market squeeze in the underlying securities if ETF providers recalled on-loan securities on a large scale in order to meet redemptions. In addition, the use of ETFs as collateral in a long chain of secured lending and rehypothecation may create operational risks and contribute to the build up of leverage.

Note that the US has pretty strict limits on rehypothecation, and recall that the lack of similar rules in the UK was a big (we’ve also warned about doomsday machine-type rehypothecation schemes). In case this concept is new to you, an overview from a 2010 post:

Despite its daunting name, rehypothecating is not that hard to grasp. Imagine you operate a pawn shop. People bring things that are valuable and leave them with you as collateral for loans. In rehypothection, you as the pawn broker have gotten permission from the people who have provided their assets to you to take them to another pawn broker and get a loan from them.

You can already see this sounds dodgy. How many times might your gold watch be passed from pawnbroker to pawnbroker? And if the pawnbrokers were each willing to lend a high percentage of its market price, the loans made against this one watch could easily exceed its value.

The irony is that the US recognized the potential for abuse with rehypothecation long ago and provided for strict limits during the Depression. The Securities Exchange Act of 1934 limited the level of rehypothecation to 140% of customer loan balances. The rest of the assets must remain in a segregated account. By contrast, as Singh and Aiten remind us, there are no restrictions on rehypothecation in the UK and no customer protection laws (the US also has SIPC to provide some restitution in the event of a broker-dealer failure). The lack of restriction in the UK allowed hedge funds and dealer prop trading desks to achieve higher levels of leverage, but left many funds badly exposed when Lehman’s London operation, which had rehypothecated customer assets, collapsed. Needless to say, that mess has made participants a good bit more careful, with the result that the paper estimates that the total amount of assets that were permitted to be pledged fell from $4.5 trillion at the end of 2007 to $2.1 trillion at the end of 2009.

Note that rehypothecation is a source of funding to dealers (remember, if your pawnbroker can get a loan against your watch, he can use it to fund his business).

And that’s why both these practices bears some scrutiny. As the IMF warns:

Bankruptcy laws surrounding counterparty defaults and the potential freezing up of collateral at custodial banks remain areas of concern for ETFs involved in TRS [total return swap] and securities lending. In a variation of the swap-based ETF, the provider sometimes transfers all the cash from investors to the TRS counterparty, which in turn pledges collateral to the ETF’s account at the fund’s custodian bank.73 In such a scenario, if the swap counterparty were to default, it could potentially lead the bankruptcy administrator to freeze all ETF assets, preventing the ETF from liquidating its assets if the need arises. Also, the TRS counterparty has an incentive to provide lower-quality collateral in such an exchange, leaving the ETF provider with potentially illiquid assets to offload in the case of a default of the counterparty.

The good news is that Amery highlighted various ETF sponsors putting out press releases, some of which were pretty disingenuous. It appears that these reports are laying the groundwork for clearer disclosure and tightening of some rules. But how quickly that happens and whether it gets the Eurobank affiliated funds out of the dodgy business of providing cash to their sponsors remains to be seen.