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Shadow Banking Probe Encompasses ETFs
By Paul Amery | 03 May, 2012

The financial crisis made it clear how little most of us—regulators, politicians, academics and investors—knew about the inner workings of the global monetary system. A depositor “run” from less-regulated, off-balance sheet financial structures, starting in the summer of 2007, ended up bringing the whole banking system to near-collapse a year later, requiring massive and costly intervention by governments and central banks.

Since the depths of the financial crisis many researchers have focused on achieving a better understanding of the so-called “shadow banking” system, as this complex, semi-official financial network has come to be known. Regulators, government officials and central bankers, meanwhile, have been preoccupied with avoiding a repeat of the collapse.

In early 2011 global regulators drew connecting lines between their shadow banking enquiries and exchange-traded funds (ETFs), hitherto a relatively obscure sub-sector of the asset management industry. In a series of public statements, researchers from the International Monetary Fund (IMF), the Bank for International Settlements (BIS) and the G20 Financial Stability Board (FSB) expressed concerns that the boom in ETFs might be contributing to renewed systemic instability.

Of particular concern, said the IMF, BIS and FSB, was the possibility that ETFs’ promise to investors of instant liquidity might compromise the funding position of a bank acting as counterparty in a derivatives transaction. ETFs’ widespread involvement in securities lending was highlighted as another potential cause for worry, said the IMF, given the opacity of such lending activities and the lack of consistent guidelines to regulate them.

As part of the policy response to these concerns, ESMA, Europe’s securities market regulator, launched a discussion paper last summer on the future regulation of ETFs. The European regulator followed up with a consultation paper in January this year, setting out new draft guidelines for ETFs and making it clear that it was widening its investigation to look at all UCITS funds (UCITS is the brand name for investment funds approved for retail distribution in the European Union, with most of the region’s ETFs fitting into this category).

In its guidelines, ESMA places particular emphasis on controlling funds’ use of derivatives and their activities in the securities lending market, proposing more systematic disclosures and tighter rules for the collateral involved in such transactions.

But even if regulatory changes are already underway for Europe’s ETF market, an intense global debate continues about the broader, systemic impact of certain investment vehicles and types of financial transaction. Last Friday, in a high-profile gathering at the European Commission’s offices in Brussels, politicians, regulators and academics joined to subject shadow banking to public scrutiny. Among fund types, ETFs and money market funds were key areas of interest. Among financial transactions, securitisation, securities lending and the repurchase (or “repo”) market were also highlighted as areas for potential concern.

A definition of “shadow banking”, given at Friday’s conference by the Bank of England’s deputy governor, Paul Tucker, makes it clearer why such fund structures and transaction types are in the spotlight.

“Shadow banking,” said Tucker, “is credit intermediation, involving leverage and maturity transformation, that occurs outside or partly outside the banking system.”

Credit intermediation by non-banks is not, in itself, a bad thing, said Tucker, a point that Michel Barnier, European Commissioner for the internal market and services, and several other conference speakers were also keen to stress. But the fact that shadow banking structures are able to do what banks do—that is, to take deposits and lend out a multiple of that deposit base, or to raise funding in the short-term markets and lend longer-term—means that they require extra supervision, Tucker argued.

Take, said Tucker, securities lending as an example. The lending of portfolio assets is widely used in so-called “physical” ETFs—those that own the securities in the index being tracked, or a sample of them—as a way of enhancing returns. In synthetic (derivatives-based) ETFs, a transaction similar to securities lending occurs when a fund holds a basket of securities that offers a lower potential revenue stream in the lending market than the index securities themselves. Such practices generate significant extra revenues for the firms involved, by one estimate potentially doubling what issuers earn from funds’ headline fees.

“Anyone holding a securities portfolio can build themselves a shadow bank using the securities lending and repo markets,” Tucker pointed out. “One simply lends out the securities at call for cash, and then one employs that cash by making loans or buying credit-assets with a longer maturity. This is leverage and maturity mismatch.”


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