ETFs can be a source of systemic risk because they can induce important feedback effects in markets, such as increased volatility in periods of market stress. However, these effects can be mitigated by regulators, according to a research paper by Maureen O’Hara (pictured) of Cornell University and assistent-professor Ayan Bhattacharya of the City University of New York.
The two scholars compare ETFs to social networks such as Facebook: they offer many benefits, but also have ‘systemic impacts that cannot be wished away’ such as the uncontrolled spread of fake news.
In the case of ETFs, a major systemic effect arises from their passive structure, according to the authors. ‘The long-term effects of the erosion of active investing that passive instruments such as ETFs have engendered are slowly unfolding in the markets’, they argue. Morningstar has estimated that 48% of all US stocks were held by passive index-tracking funds in December 2018, and by July 2019, this number crossed the 50% mark.
Herding behaviour
‘When the first Standard & Poor’s Depositary Receipt (SPDR) ETF was launched in 1993, index products were envisioned as passengers in a car driven by underlying markets. Because of a multitude of factors, the roles have now reversed in many markets, with ETFs in the driver’s seat and underlying markets relegated to the status of mere passengers. ETFs were admitted into the car as passengers, which means they never had to pass a rigorous driving test. In other words, we do not know how well they drive.’
As passive investing leads to indiscriminate asset flows, it encourages herding behaviour by investors. ‘This turns potential weaknesses into systemic risks, allowing problems in one market to easily spill over into other markets.’
Step away risk
A second set of systemic issues concerns the role of ETFs in market disruptions. ‘In recent years, the frequency, suddenness, and ferocity of such disruptions have surprised both regulators and market participants.’ Demand for buying and selling ETFs characteristically rises considerably during systemic shocks, such as the Taper Tantrum in 2013, when underlying markets are frozen and difficult to trade. ‘Thus, at least momentarily, trading in ETFs becomes a significant fraction of the overall market trading.’
In times of stress and thin liquidity, it can become ever harder for brokers/dealers to execute ETF transactions as only a small number of instruments in the basket will have enough liquidity. ‘A particularly important aspect of this (…) risk is “step away” risk—the possibility that in times of market stress, authorized participants may scale back or even step away entirely,’ the authors argue.
One reason this “step away” risk can take on systemic importance is that it affects money managers holding ETFs in other types of funds. The rise of fixed-income ETFs has led many asset managers to use ETFs for cash management, the authors note. ‘This practice of using ETFs as cash equivalents is only appropriate, however, if the ETFs can always be turned into cash immediately.’
Circuit breakers
What can regulators do to address these concerns? The authors suggest they be careful using circuit breakers, a draconian measure which stops trading when big price swings occur. ‘For ETFs on underlying asset markets that are ordinarily easy to buy and sell but are afflicted by sudden bouts of illiquidity from time to time, circuit breakers might be a useful tool, if properly implemented. In particular, circuit breakers could be designed to kick in when underlying illiquidity threatens to generate a herding spiral.’
For underlying markets that are chronically illiquid, however, regulators might be better served by addressing the root issues that lead to disruptions. ‘For the ETF mechanism to function well, underlying markets need to be transparent, prices need to be readily available, counterparties need to be easily accessible and volumes need to be sufficiently high.’