Smoldering concerns internationally that exchange traded products (ETPs) could spark the next global financial crisis have come to a head with the release of a paper by the international Financial Stability Board that calls for greater attention from regulators worldwide.
The Financial Stability Board was established in April 2009 as the beefed-up successor in the wake of the 2008 global economic crisis to the Financial Stability Forum (FSF) which was founded in 1999.
The board has warned that the products, which by the third quarter of last year had attracted more than US$1.2 trillion from investors, contain “a powerful source of contagion and systemic risk”. About half the amount invested comes from retirement savings.
The basis of exchange traded products is to provide the market performance measured by various price indices.
For example, the vanilla tracker product, the Satrix 40 Exchange Traded Fund (ETF) tracks the performance of the top 40 (by market capitalisation) shares listed on the JSE, while the Standard Bank silver exchange traded note (ETN) tracks the daily price of silver.
The main concern raised by the Stability Board is how ETFs, particularly in Europe and Asia, which started off as vanilla instruments tracking various stock exchange indices and holding the underlying securities in their portfolios (termed physical ETFs), have rapidly expanded into what it calls synthetic (derivative) products.
In South Africa exchange traded funds are more rigidly regulated than in Europe and Asia through the Securities Exchange Act and the Collective Investment Schemes Control Act (Cisca).
However, many of the structures that concern the Stability Board are available in South Africa through JSE-listed exchange traded notes (ETNs), as well as capital-guaranteed, index-linked structured life assurance products.
South African regulators, as well as the financial services industry in South Africa have heeded the warnings of the Stability Board.
Financial Services Board (FSB) chief executive Dube Tshidi, says the products are receiving the attention of the National Treasury and the FSB.
Leon Campher, chief executive of the financial services industry body, the Association for Savings & Investment SA, says the association is co-operating with the authorities on how the products should be regulated to protect investors.
The main concerns of the Stability Board are:
l The synthetic nature of the ETPs, in that they do not invest in the underlying securities whose fortunes they profess to track, but use derivatives to match the performance of the chosen index.
l Leveraging: There is often extensive use of leveraging to provide a multiple of the performance of the selected index, increasing potential losses.
l Counter party risk: The synthetic products are debt instruments with guarantees provided by banks. The counter party risk is opaque, as it is not always clear how great the risk actually is, and where it lies, in that it could be laid off by the banks elsewhere.
With the synthetic products investors are effectively given a promissory note (debt instrument) that they will receive an amount linked to a pre-selected index or basket of indices. The guarantee that you will be paid comes from a bank, which in turn should hold sufficient reserves to meet the guarantee.
The Stability Board says with synthetic products “the provider (typically a bank’s asset management arm) sells ETF shares to investors in exchange for cash.
“This is then invested in a collateral basket, the return of which is swapped by the derivatives desk of the same bank for the return an index. Since the swap counter is typically the bank also acting as the ETF providers, investors may be exposed if the bank defaults.”
What bothers the Stability Board is whether sufficient reserves are being held by the banks, particularly at times of financial crisis when there could be substantial sell-offs by investors – a run on the bank.
l The opaqueness of the risks. The Stability Board is worried about whether the risks being held on the balance sheet of a particular bank providing the guarantees are fully disclosed and assessed.
This includes both problems of conflicts of interest and risks being laid off elsewhere.
The board says “(any) problems at those banks that are most active in swap-based ETFs may constitute a powerful source of… systemic risk”.
The risks may also be traded off to another institution, creating a domino effect similar to the 2008 sub-prime mortgages meltdown.
The now well-documented 2008 crisis was caused by the way home loan debt was bundled up by banks into what are called securitisations and were sold off to other investors (mainly institutions) which then in turn bundled the securitisations into further bundles, with the claim that this would reduce the risk.
What in fact happened was that as more and more home loans were not repaid, the bundles of debt became toxic. The board says the incentives behind the creation of synthetic ETFs may not be aligned along the ETF chain, “especially as conflicts of interest can arise from the dual role of some banks as ETF providers and derivative counterparty”.
l Potential liquidity problems: As the products are listed securities, they can be sold on demand by investors. However, the underlying assets of synthetic products are less liquid, creating an unwind problem in the event of an investor sell-off.
l Securities lending risk: This risk more directly affects physical products (ETFs in South Africa) where the scrip owned is lent in derivative markets, with “rental” being used to reduce costs or increase profits of the ETF sponsor.
This could create counterparty and collateral risks, as well as liquidity risks, if there are strong investor outflows.
The Stability Board says greater attention is required from regulators worldwide and frequent full disclosure is required on all issues “to enable investors to exercise their due diligence and promote a better understanding of the ETF market at large”. - Bruce Cameron