Fuhr: Is BoE sounding the warning bell on the right ETFs?

 The Bank of England (BoE) has reiterated its call for greater education and transparency with regards to synthetic exchange traded funds (ETFs). 

Although ETFs have always been among the most transparent types of funds, we are still hearing from regulators and investors that more education and transparency is needed.

On 29 June, the BoE published its Financial Stability Report, in which the bank repeated many of its criticisms of synthetic ETFs outlined in its 2011 report. The bank rated ETFs as high on ‘increasing complexity’ and ‘less meaningful information’. 

Harsh criticism

Many would find the description a bit harsh – especially referring to them as ‘particularly opaque’, as most synthetic ETF providers have increased the type and amount of information provided on counterparties and collateral in synthetic ETFs after concerns previously highlighted in 2011.

Indeed, reports by the Bank for International Settlements, the Financial Stability Board, and European Securities and Markets Authority last year highlighted risks from the perspective of investors, providers, swap counterparties and market makers, as well as from a market point of view. 

In contrast, physical ETFs did not make the BoE’s Financial Stability Report, nor are they even mentioned. 

The latest report from the BoE states: ‘There is a wide range of opaque funding structures that complicate the monitoring and assessment of the risks that banks face. 

‘The risks due to opacity are higher for instruments that have complex structures and where little meaningful information is available. 

‘The most complex funding structures include those where credit risk assessment requires models and counterparty stress testing, liquidity risk assessment requires behavioural modelling and risk assessments are blurred by many layers of interconnections.’

It added: ‘These opaque instruments may amplify stress within the financial system, by acting as drains on collateral or liquidity. 

‘Opacity can also result from transactions to reduce regulatory capital charges. Complex intra-group booking practices are another factor increasing opacity in the financial system. It has been common practice for many international investment banks to transfer market risk to unregulated entities via intra-group transactions.’

Regulators and investors are still researching and discussing how they should treat ETFs in the future. 

Synthetic and physical ETFs are seen as being significantly different in their structure and potential risks.

Publishing guidelines

We are awaiting the imminent publication of the guidelines from the European Securities and Markets Authority on Ucits ETFs and other Ucits-related issues. 

These guidelines will be based on responses to the consultation paper at the end of January. They will cover both synthetic and physical Ucits ETFs and are also expected to detail the obligations for Ucits ETFs, index-tracking Ucits, efficient portfolio management techniques, total return swaps and strategy indices for Ucits. 

It is worth reminding ourselves that for all the rigorous debate within the ETF community, we are talking about exposures within a highly regulated investment funds framework. 

While there may be concerns around the quality or liquidity of swap collateral or the robustness of a securities lending programme, it is important not to lose sight of the fact that from an investor perspective, their investment is through a highly regulated entity and all exposures have strict parameters while the investment itself is well protected in its fund wrapper.

Investments in non-fund structured exchange traded products, meanwhile, have effectively no regulation – either of the investment exposure itself or the delivery mechanism of that exposure.