The exchange traded exposures at risk of eurozone bank implosion

The genesis of concern about exchange traded funds (ETFs) stems from their rapid growth and, more significantly, the security of uncollateralised exchange traded notes (ETNs), which are coming to the fore as the eurozone crisis heats up.

Worries over ETNs emerged at the height of the credit crunch when the issuers and backers of these notes, principally investment banks and insurance giants, wobbled after the Lehman collapse.

The irony remains that in the EU, most regulation is attached to the already highly regulated funds sector, with ETFs offering protection above a high watermark.

In contrast, ETNs are effectively part of an unregulated market, yet they will recover the ground lost at the height of the crisis without participating in this debate or level of scrutiny.

Concerns will remain

As memories of counterparty exposure and risk fade, or at least fade from immediate concerns, investors will one day return to market investments where neither the exposure nor the protection might be considered suitable for the unadvised retail investor.

The continuing uncertainty in the eurozone, with the possible contagion risk for those issuer banks, means it is likely that counterparty risk for private issuers – let alone public ones – will remain a real concern for some time.

Notwithstanding that focus, the regulators are mindful that something needs to be done in this area to provide a long-term solution.

In the initial report of the Financial Stability Board to the European Securities and Market Authority Consultation Paper on ETFs, they have opined that some level of regulation or distinction around non-fund exchange traded structures will be required.

It is not enough, as some providers have suggested, that the investor has access to the prospectus or offering document of the note or debt security structure. Even worse, the current level of regulation allows the retail investor to access these often complex, high-risk or low-safeguard products without seeing that prospectus or being advised as to the nature and risk of their investment.

This situation is not optimal, but perhaps acceptable, with regard to funds and some of the exposures they offer, but is undesirable with respect to non-fund structures.

In our view, the progress in Markets in Financial Instruments Directive and Packaged Retail Investment Products may, and hopefully will, ultimately level the playing field so that investors in funds and notes will at least understand better the distinction between them.

It will also have restricted product offerings and have the suitability concerns addressed at the point of distribution through prohibition on access based on expert advice only – meaning the free-for-all through the unadvised brokerage account may end. It could be proposed that an investor might be advised to think about all exchange traded offerings under the generic term ‘exchange traded exposures’.

The benefit of such a term is that it does not, unlike some terms in loose usage, imply the nature of the product and more particularly its regulation. It is a term more akin to the nature of the investment risk assumed – a concept which is generally easily understood.

The second limb is to consider how that investment risk is delivered to you as the investor and what additional risks you assume. There is a need to distinguish between ETFs and all other exchange traded exposures – be it a generic term such as exchange traded products or a labelling of the individual product types.

Understand exposure

For the investor, the point remains that once they are made aware that their exposure is outside the highly regulated world of their investment and structural protections in the funds arena, they can understand the unregulated nature of their investment and proceed with caution.

Non-fund products should never use or be loosely associated with the term ‘ETF’. The loosely defined nature of what an exchange traded exposure can be means there is no right answer, but there are wrong intentions that muddy the waters as to the risks undertaken.

The industry could do well to seek an agreed solution in advance of a necessarily imposed one.