The Central Bank of Ireland director general has indicated that the new regulatory framework it is currently consulting on will concentrate on liquidity concerns, the implications for Mifid II and the role of authorised participants in secondary markets.
Speaking at a conference in Dublin last week, Derville Rowland from the CBI warned that innovation such as that represented by the rise of ETFs brings with it the need to “continuously assess” potential risks.
“In particular, remembering the hard-learnt lessons of the financial crisis, we must be mindful to assess new market innovations through the prism of a risk-centred approach,” he said.
Ireland is an important European ETF hub. It is home to 730 Irish-authorised ETFs representing more than €333bn in assets under management and some estimates suggest this figure to rise to €800bn by 2012. It has, as Rowland said, global reach.
Such large numbers bring with them concerns over liquidity – or the lack of it – in “certain asset classes”. Rowland went on to cite the example of the high-yield bond market where “questions in relation to resilience have been asked.”
He noted, though, that it was important to recognise that the UCITS framework “provides very substantial protections in relation to liquidity.” “Significant duties and obligations are placed on ETF providers in relation to assessments and sustainability of liquidity,” he added.
These will be bolstered under the incoming Mifid II regime which includes a requirement for trading venues to incentivise liquidity provision.
“Now that trading venues must incentivise official liquidity providers to maintain their presence in stressed market conditions, regulators will be watching the development of different models and how successful these are with interest,” he said.
The role of authorised participants (Aps) will also be addressed by the framework. Rowland pointed out that ETFs integral to the chain of supply to the market of ETFs.
“The risk that the AP mechanism might fail to function may seem remote,” he added. “Until now, it appears that market forces have addressed any faltering of the AP mechanism.”
However, he pointed out that there were questions about the impact of Aps stepping away from the ETF market in times of market stress.
“If an AP mechanism ceases to function, it is not clear what would happen,” he said. “Much of the trading in an ETF does not involve the AP, so trading may continue as normal, at least for a time. But it may not. Trading volumes can display highly unpredictable levels of resilience to shock.”
This has particular relevance to secondary markets where there is the potential for investors to be left in the “invidious positon” of having to near the cost of widening spreads which as disassociated from the prevailing NAV. Rowland questioned whether in such circumstances investors would find themselves without a counterparty they can trade with and whether this is the trade-off for being able to purchase a fund which can be traded on an intra-day basis.
“All this illustrates that the role and functioning of APs and secondary market liquidity is complex and deserves further reflection,” he said. “As responsible regulators, we are tasked with understanding these questions and the impact of the answers.”
He concluded by pointing out that it was the very success of ETFs in recent years which made these questions that much more important right now.
“When the ETF structure represents a small share of the market (some estimates are that only 8% of the global market is invested in ETFs), it makes sense to have a high tolerance for unlikely events,” he said. “When ETFs are more important to the functioni