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Voices: Regulators are asking the wrong questions about ETFs

The European Systemic Risk Board, which was created to prevent a repeat of the financial crisis, is out with a new report examining ETFs. It’s worthy endeavor, given that the market for ETF’s has grown to $5.6 trillion, raising questions about whether these vehicles have the potential spark another crisis despite being created at the urging of the SEC in order reduce the risks that were revealed in the stock market crash of 1987.

But the report is fundamentally misguided because it underscores how systemic-risk regulators are charged with avoiding all risk rather than balancing risks in an optimal way. The report asks, “Can you imagine a systemic crisis with ETFs?” rather than, “Do ETFs increase or reduce the probability or damage of a crisis?”

Aaron Brown, chief risk manager for AQR Capital Management LLC, and author of The Poker Face of Wall Street and A World of Chance, speaks during the 2010 Milken Institute Global Conference in Los Angeles, California, U.S., on Tuesday, April 27, 2010. This year's conference is titled "Shaping the Future" and runs until April 28. Photographer: Jonathan Alcorn/Bloomberg
Aaron Brown, chief risk manager for AQR Capital Management LLC, and author of The Poker Face of Wall Street and A World of Chance, speaks during the 2010 Milken Institute Global Conference in Los Angeles, California, U.S., on Tuesday, April 27, 2010. This year's conference is titled "Shaping the Future" and runs until April 28. Photographer: Jonathan Alcorn/Bloomberg *** Local Caption *** Aaron Brown

The first systemic risk in the report is the high liquidity of ETFs, which it says increases market volatility and correlation among assets. But there’s plenty of evidence that liquidity helps prevent and mitigate crises. Investors trapped in illiquid positions, excessive price moves caused by fire sales into illiquid markets and panic due to untrustworthy price quotes are major contributors to panic.

The report is mainly concerned with European bond ETFs. For a simple example, assume transaction costs average 0.5% to trade an individual bond and 0.05% to trade an ETF. When news moves the overall bond market by less than 1%, there’s no profit in trading on it immediately. You pay 0.5% to get into the position, and 0.5% to get out. So the news will leak into individual bond prices slowly as investors buy and sell for other reasons, or new corporate bonds come to market. Measured volatility and correlation are suppressed.

Liquid ETF trading will reveal true volatility and correlations. Accurate information reduces systemic risk, not false-but-reassuring information.

Another issue is this compares ETFs to individual bond trading. But without ETFs, arbitragers could do the same thing with derivatives. This creates more systemic risk because derivatives are levered, and settle differently from stocks and bonds. Those are two of the big reasons the SEC wanted an unlevered alternative that traded as a stock. Leverage and settlement gaps are systemic risks.

This brings up another problem with systemic risk regulators, as opposed to financial regulators who keep relevant by making daily decisions. The main academic studies used in the paper were published from 2009 — 2016, and were mostly based on data before 2012. The recommendation is for more study.

Electronic and portfolio trading are changing bond trading today more than ETFs, which after 25 years of experience are known quantities by comparison. Moreover, the study worries a lot about leveraged and synthetic ETFs, both of which were of greater concern 10 years ago and speak more to issues of protecting retail investors than systemic risks. By the time the ERSB makes up its mind about ETFs, and translates that into effective regulation, it will be attacking 20-year-old problems. In modern financial markets that’s as relevant as regulating ancient Mesopotamian grain trading.

The second and third issues in the report result from trading in ETFs likely spiking in a crisis, without a commensurate increase in individual bond pricing. This could lead to ETF prices deviating significantly from the prices of individual bonds that make them up. Again, this is the point. Without ETFs, portfolio managers who need cash for redemptions, or want to reduce exposures, have to sell whatever bonds they hold. The buyers willing to take on exposure may not be looking for those specific bonds. ETFs bring all the people who are trading for various market reasons—as opposed to having opinions about individual bonds—to one place where they can find the market-clearing price quickly without fear of adverse selection or winner’s curse. Also, since one ETF trade can substitute for dozens or hundreds of individual bond trades, the markets are less likely to be overwhelmed.

The losers “offer exposure to extremely narrow and volatile segments of the market,” an expert says.
June 13

Finally, the report worries about an operational problem in ETFs sparking a crisis. That’s certainly possible, but ETFs are among the simplest financial products and unlevered. When MF Global failed with inadequate segregation of customer funds, there were weeks of uncertainty and major jurisdictional complexity. When Lehman Brothers failed, with its complex business and high leverage, it was a multiyear nightmare. If an ETF dealer failed suddenly, some of its counterparties might be uncertain which trades done shortly before the failure would be honored, but it’s hard to see it leading to a systemic crisis or taking long to resolve.

Instead of asking, “would it be bad if an ETF dealer blew up?” the relevant question is, “given someone blows up, would you rather it was an ETF dealer or some more complicated and leveraged financial institution?”

I don’t mean to suggest the ESRB report is useless. It’s a pretty good summary of ETF research over the last decade, and it mentions many positives about ETFs. But its title question is not useful to anyone. Anything “can” cause a systemic crisis, but some things make them less likely and less damaging if they occur.

Bloomberg News