Last November, as part of its Financial Stability Review, the ECB, in a paper entitled Counterparty and liquidity risks in exchange-traded funds, warned ETFs have the potential to amplify risks in financial system.
In particular, the Bank highlighted liquidity risk in the primary and secondary markets and counterparty risk in synthetic ETFs and those engaging in securities lending as the two main sources of potential impact.
Michael Grill, ECB regulator and co-author of the report, said at the time: “Liquidity and counterparty risks…could be addressed by either enhancing currently applicable frameworks or by developing an ETF-specific regulatory framework.”
In its response to the ECB, EFAMA said further ETF regulation is not currently “warranted” as ETFs, during periods of market volatility, have proven resilient and, in some instances, as a useful tool for exchanging premia and risks where individual securities have been unable to trade at all.
EFAMA said: “We believe that some of the regulatory concerns being voiced around ETFs are misplaced.
“[Instead of an ETF-specific regulatory framework], EFAMA would support a more cautious and piecemeal review process which leverages off an open and transparent consultation method, as well as off the wealth of experience of market supervisors in authorising and supervising ETFs.”
On the issue of ETF liquidity, EFAMA blasted the ECB for failing to adequately consider the “deep and liquid” secondary market ETFs have.
While the ECB said the ETF structure is largely depended on the commercial incentives of the market participants involved, EFAMA pointed out the average daily trading volumes in ETFs are far larger in the secondary market, away from any primary creation-redemption performed by authorised participants (APs).
Furthermore, EFAMA noted how APs typically prefer to hold onto ETF inventory in the knowledge that in more volatile markets there will be more opportunities to offload those securities in the secondary market.
“An AP’s discretion exercised in such instances should thus be appreciated as an important element that 'brakes' the alleged forced selling of an ETF’s underlying securities,” the report added.
In terms of counterparty risks, EFAMA said the ECB’s concerns “are not new” with the European Securities and Markets Authority (ESMA) already making a number of recommendations in 2012 about on the issue of swap-based ETFs.
While the ECB said “most ETFs rely on a single counterparty”, EFAMA noted how European ETF providers implement a synthetic replication model through a multi-swap counterparty platform.
This, the report said, can be “as many as seven different non-affiliated counterparties to the total return swaps with the provider’s own ETFs”.
The European association added: “Regardless of the number of swap counterparties, it is more important for the ECB to appreciate that underpinning each swap counterparty appointment is a robust due diligence and counterparty selection procedure, commonly known as a Request for Proposal (RFP), whereby swap counterparties are screened and ultimately chosen on the basis of pre-defined legal and economic criteria.”
EFAMA concluded by calling for a classification system that makes a clear distinction between ETFs, which are UCITS-licensed, and other exchange-traded products (ETPs).
"Such a scheme is intended to help investors more readily assess the risks inherent to each type of ETP, as well as aid regulators to better focus their efforts at protecting investors and guarding financial stability.
“We believe that any further regulatory action should be carefully calibrated based on evidence, a clearer understanding of the interaction between ETFs and their broader ecosystem (including APs, market-makers and exchanges), as well as on existing regulation.”