Regulators ask: Are ETFs the next CDOs?

Regulators are comparing ETFs with collateralised debt obligations, but do the two seemingly different products share any common ground?

If regulators were caught napping by the last financial crisis, they look determined to avoid a repeat this time around. For many, however, they are barking up the wrong tree in suggesting that ETFs could serve as a transmission mechanism in the same way collateralised debt obligations once did.

ETF providers point out that, beyond sharing three-letter acronyms for titles, the two products have little else in common.

“It comes down to a question of collateral,” said Christopher Aldous, chief executive of Evercore Pan-Asset Capital Management, a firm that invests most of its £500m assets in ETFs. “People are saying they are the same thing. I would disagree, for the principal reason that a CDO is built of lower quality assets that are repackaged, in many cases with gearing involved.”

Under the CDO structure, issuers would typically take a bundle of assets, borrow against those assets, then package together assets and borrowings. The next step was to persuade a ratings agency to give the product, or at least parts of it, a triple A-rating. Investors flocked to buy the securities because, although the product was typically triple A-rated, it offered a slightly higher yield than anything available elsewhere.

In contrast, a standard ETF structure does not involve borrowing, although investors should be careful to check what they are buying, since exchange-traded notes, products and commodities usually rely on more complex structures.

“I would characterise the comparison as unnecessary and sensationalist,” said Ben Johnson, director of European ETF research at Morningstar. “Both products have three-letter acronyms, both have experienced rapid growth, or, rather, the CDO market did while it was around, and each of them represents a stake in a portfolio of financial assets. That is where the similarities begin – and end.”

Despite the massive and much-publicised growth of the ETF industry, it still accounts for only a fraction of the trillions of assets held in mutual funds. This limits the ability of ETFs to perpetrate the type of harm feared by regulators.

Yet regulators may have seized on the wrong target in their attempts to prevent any repetition of the financial crisis. “ETF providers are repackaging a swap into a cash-based collateralised instrument, centrally traded and centrally cleared,” said Johnson. “Regulators should welcome this as a massive step forward.”

Johnson added: “An ETF allows you to invest in exchange-listed assets at readily transparent prices. This really contrasts strongly with illiquid mortgages that had little or no indicative pricing.” ETFs also have the security of a third-party custodian, not something that featured in CDOs.

So why are regulators singling out ETFs for scrutiny that users and analysts insist is unfair? “Driving this is the concern among regulators to make sure that investors receive adequate education,” said Johnson. “Because ETFs are new and rapidly growing, they are the new kid on the block and facing a high degree of scrutiny.”

In a recent working paper for the Bank of International Settlements (BIS), economist Srichander Ramaswamy wrote: “There are a number of channels through which risks to financial stability could materialise from ETFs, especially when product complexity and synthetic replication schemes grow in usage.”


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