Regulators voice fears over danger to retail investors

Fund Strategy - 10 Oct 2011 | By Rodrigo Amaral

Kweku Adoboli, the trader at the centre of the UBS scandal, is accused of using sophisticated operations to fake ETF trades and hide speculative bets. But regulators argue that even straightforward, physical ETFs raise problems that need to be addressed, not least because they could put retail investors at risk.

The Financial Stability Board (FSB) has expressed concerns that although physical ETFs invest directly in an index’s underlying securities, they work with thin margins, which generate incentives to look for further sources of revenue. As a result, many of them are active participants in securities lending arrangements, which carry additional risks. According to Deutsche Bank, some ETFs derive up to one-third of their revenues from the fees borrowers pay for their securities.

In these transactions, ETFs lend their assets to some other player in the market, such as a bank or hedge fund, which will use them for a particular purpose, such as short-selling bets or repurchasing operations. The borrower pays a fee and sends back some form of collateral to the ETF as a guarantee that the value of the assets borrowed will be reimbursed.

As the trades are collateralised, securities lending operations might seem a sensible way to derive additional profits. ETFs lend the underlying securities to large financial institutions which, once the lease of said assets is over, return them to the original owners. If everything goes to plan, stocks come and go out of their books, leaving a trail of fees in the process, which are partially or totally returned to the funds. If problems arise, the ETFs can liquidate the assets deposited as collateral and buy the assets that their investors expect to be holding. When it works efficiently, the operation seems low risk. (News analysis continues below)

But many regulators have concerns. Lehman Brothers, the former American investment bank, was a big operator in the market, as was American International Group (AIG). After the collapse of Lehmans, some lenders of securities struggled to get their assets back or to redeem collateral as they tried to reduce their connection with both firms.

Liquidity can also be a concern. In Europe, borrowers rarely send cash guarantees to securities lenders. As one of the main goals of borrowers in securities lending is to obtain greater liquidity, the assets offered as collateral are often less liquid than those that are borrowed. In the event of a market run, ETFs could find it hard to pay back clients if they have large amounts of illiquid assets on their books.

Many investors in ETF-type products may not be alerted to the pitfalls of counterparty and liquidity risk. In a recent report, Morningstar noted that investors would be surprised to learn that up to 100% of their funds’ assets are lent out to short sellers or hedge funds.

Regulators have expressed particular concern over the possibility that banks that own ETF providers will use these transactions to tap cheap sources of liquidity. This could become a problem for ETF investors if dire predictions over the fate of European banks become reality. The FSB has also expressed concern about the use of ETFs as collateral in long chains of securities lending and rehypothecation (banks’ use of collateral deposited by clients as collateral for other transactions), a practice that adds to risks in the financial markets.

Regulators argue that the growth of collateralised structures and securities lending operations has contributed to turning many ETFs into complex products from the straightforward assets that they initially appeared.

In July the European Securities and Markets Authority (ESMA) launched a consultation to assess whether such products should lose their Ucits status or even be prevented by law from being sold to retail investors. A particular concern is the need for more transparency over securities lending operations, although ESMA admits this is not an ETF-specific risk.

Investors need to have more information. Last week BlackRock, the world’s largest ETF provider and owner of iShares, expressed support for measures that would guarantee investors receive better information about the holdings and exposures of their funds.

Liam Butler, the managing director at Northern Trust Securities Services, says that properly serviced ETFs have the capabilities to provide transparent and up-to-date information to investors and counterparties. As part of this, providers need to ensure that clearance, settlement and other back office operations are more efficient.

Ben Johnson, a director of ETF research at Morningstar, agrees. He says that the post-trade, clearing and settlement processes are fragmented and inefficient, especially owing to the large number of jurisdictions where transactions are cleared. “It can create a good deal of confusion and costs for investors,” he says.

Some critics argue that Adoboli, a former back office employee, may have known about such inefficiencies and how to exploit them to set up fake ETF transactions. For the sake of transparency, cost-effectiveness and risk management, the ETF industry could make sure these problems are addressed and all funds adopt best practices in servicing assets.

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