ETFs pose financial stability risk

1st July 2011

Financial regulators should be alert to the potential for destabilising asset bubbles posed by new financial products that are growing in demand as investors seek higher returns in a low interest rate environment, said Paul Fisher, one of the bank's senior watchdogs.

As reported in the Daily Telegraph, he said: "Investors know – and must remember – that there is no such thing as a free lunch, and that additional return involves additional risk."

Intelligence gathered by the Bank has flagged up a "number of pockets of increasing risk appetite and a few specific markets which have been showing signs of excess," he said, with the trend most marked in the US.

He highlighted exchange traded funds (ETFs), which are traded like shares. Their rapid growth has been characterised by "increasing complexity, opacity and interconnectedness, and … if left unchecked, could grow to pose risks to the stability of the financial system", he said.

ETFs have become a particular focus of anxiety for regulators, who believe they could pose greater risks than are properly understood by many investors. ETFs, which track specially created market indexes, are being used as investors try to bolster returns. The market has grown quickly and is estimated to be worth $300bn (£190bn).

Nocolours comments on the Guardian report: "Basic innovation such as shorting reduces volatilty, which is a good thing and the reason the Chinese recently went down the path.
Complex and none transparent innovation such as CDO's and ETF's can cause volatility.
Regulators need to be proactive. In the UK the system at least is being mended and the tripartite disaster. Hopefully the action isn't too late. This story has been in the open for several months already!"

However, the most immediate threat to markets was seen as problems around governments' debt and the potential impact on European banks. Although markets had been on the mend since the financial crisis in 2008, the eurozone debt crisis, coupled with uncertainty about the economic recovery and the progress of banking regulation, could undermine efforts to rebuild the financial system on a more sustainable footing, Fisher said.

More here:

ETFs: All you ever needed to know  

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