The International Organization of Securities Commissions is to expand its probe into the ever-growing ETF industry as systemic-risk fears mount.
The Madrid-based regulator launched an investigation earlier this year looking at liquidity risks for mutual funds and index-linked funds, such as ETFs.
Early next year the organisation is expected to discuss its recommendations to promote better oversight of ETFs in case of market distortions in relation to the sector’s growth. It will also look at liquidity and valuation issues.
Iosco is concerned about the consequences of potential liquidity and market price shocks for ETFs at a time when central banks start to reverse their loosening monetary policies globally.
The regulator will also look at whether ETFs are changing market structures that could consequently cause a misallocation of capital across stocks and sectors.
Speaking at a a conference in Dublin, the Financial Times reported Iosco secretary-general Paul Andrews as saying: “We are on autopilot in many respects with market capitalisation-weighted ETFs.”
“Are we losing sight of fundamentals and valuation measures such as price earnings ratios because of the automatic nature of [capital] allocations by market capitalisation-weighted ETFs?”
Over the past 10 years, investors have poured around $2.6tn of new money into ETFs following disappointing performance from pricey active funds.
In a similar attempt to Iosco, the Central Bank of Ireland published a discussion paper in May questioning the need of an expanded regulatory framework for ETFs.
Speaking at the same conference, CBI director general Derville Rowland said new regulation was necessary as Ireland’s ETF industry grows.
He said: “When the ETF structure represents a small share of the market…it makes sense to have a high tolerance for unlikely events. When ETFs are more important to the functioning of markets overall, perhaps there is a point where the appetite for tolerance is tested.
“Remembering the hard-learnt lessons of the financial crisis, we must be mindful to assess new market innovations through the prism of a risk-centred approach,” he said.”
In particular, Rowland expressed concerns about the role of authorised participants in ETF markets. APs are a central part of the ETFs creation or redemption mechanisms, so they control the supply of ETF shares within markets.
Rowland said it is “remote” APs mechanism might fall but said their functioning is “complex” and needs “further reflection”.
He said: “Healthy levels of ETF liquidity can exist without any AP primary market trading. However, the question must be asked, what would the impact be of APs stepping away from the ETF, particularly in times of market stress.
“If an AP mechanism ceases to function, it is not clear what would happen. Much of the trading in an ETF does not involve the AP, so trading may continue as normal, at least for a time. But it may not. Trading volumes can display highly unpredictable levels of resilience to shock.”
FCA supervision head Megan Butler, also speaking in Dublin, echoed the concerns around APs.
She said: “More formalisation of the role of authorised participants would be beneficial, particularly in periods of market stress.”