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Potential financial stability issues arising from recent trends in Exchange-Traded Funds (ETFs)

In addition, it could make the liquidity position of the ETF fragile, by challenging the ability of ETF providers to meet unexpected liquidity demands from investors, particularly if outflows from ETFs become significant under severe stress. A prevalence of securities lending could create a risk of a market squeeze in the underlying securities if ETF providers recalled on-loan securities on a large scale in order to meet redemptions. In addition, the use of ETFs as collateral in a long chain of secured lending and rehypothecation may create operational risks and contribute to the build up of leverage. In this regard,. | FSB FINANCIAL STABILITY BOARD Potential financial stability issues arising from recent trends in Exchange-Traded Funds ETFs 12 April 2011 Table of Contents Introduction.1 1. ETFs a fast-growing market underpinned by strong innovation.1 2. Potential financial stability risks in some corners of the ETF market.3 Increase in complexity and opacity Synthetic ETFs.3 Risks for market liquidity Incentives for securities lending.4 3. Risk implications for authorities ETF investors and providers.5 i Potential financial stability issues arising from recent trends in Exchange-Traded Funds ETFs Introduction As part of its mandate the Financial Stability Board FSB monitors market developments and advises on their implications for regulatory policy1. In doing so it seeks to identify potential vulnerabilities and the actions that may be needed to address them. The recent rapid growth and innovation in the market for Exchange Traded Funds ETFs is a development that the FSB believes warrants increased attention by regulatory and supervisory authorities as well as by the ETF industry including providers market-makers and investors. This note highlights a number of recent developments that call for such attention. ETFs were created in the early nineties initially as a plain-vanilla equity product and provide investors with the flexibility and cost-efficiency of exchange-traded products together with the diversification benefits of mutual funds. Although most of the ETF market remains plainvanilla there has been an increase in product variety and in some cases complexity albeit with some differences across regions and markets. While the growth in ETF markets is at an early stage in a number of countries the speed and breadth of financial innovation in the ETF market has been remarkable in some large financial systems over the past five years and has brought new elements of complexity and opacity into this standardised market. There are a number of disquieting developments in some .