Exchange traded funds (ETFs) sit at the center of the COVID-19 crisis selloff. This isn’t surprising, since ETFs are a low-cost highly liquid vehicle for trading entire sectors, asset classes, and even global economies. Yet the use of ETFs as a preferred crisis trading tool, and the Federal Reserve’s unprecedented mid-crisis purchasing of bond ETFs, reinvigorates a long-standing debate on the systemic importance of ETF sponsors.
In a new article, I argue that the largest ETF sponsors are becoming systemically important due to interconnectedness – a material factor in the 2008 global financial crisis (GFC). Although large ETF sponsors are distinct from banks and insurance companies, there’s merit in safeguarding their economic resilience given their central interconnectedness, government bail-out potential, and ability to ignite numerous risk transmission channels in a highly complex financial ecosystem.
Moving Beyond Size: When Financial Firms Become “Too Interconnected to Fail”
Today’s financial markets exhibit both complex links and deeply interconnected firms. The GFC clearly illustrated that size is an incomplete measure of a firm’s systemic importance, and smaller, yet widely interconnected firms can also destabilize the financial system. Because modern financial markets operate as a system, if a firm sits at the center of this system, there’s merit in safeguarding its economic viability and ensuring that it won’t exacerbate shock transmissions.
My article describes numerous interconnected shock transmission channels that could emerge from the operations, or disruption, of ETF sponsors, including interlinked credit exposures, operational complexity, liquidity transformation, and contractual, sectoral, and institutional interdependencies.
How do ETFs Create Complex Economic Interconnections?
My article identifies numerous factors behind ETF growth, including passive investments’ outperformance of active ones, investor disillusionment with actively managed portfolios, and the diversification, high liquidity, tax benefits, low costs, and exposure to opaque sectors, asset classes, and novel index strategies that ETFs offer.
I show that ETF’s are, however, fostering deep and complex interconnections among various financial institutions, banks, market participants, and service providers, extending to retail and institutional investors, and affecting corporate behavior and decision-making. They function globally in a complex operational ecosystem where many participants rely on the discretion of large financial intermediaries that perform a critical arbitrage function and on secondary liquidity, and market service providers.
Even with the current crisis, mega ETF sponsors wield significant proxy voting power over publicly traded companies, including competitors in systemically important sectors like banking. I argue that they connect financial firms through securities lending, link institutional investors with corporate debtors when the former use fixed-income ETFs as cash substitutes, and influence herding as investor portfolios and risk models become increasingly correlated.
How Could ETF-Driven Interconnectivity Contribute to Financial Market Systemic Risk?
My article outlines how ETFs create both direct and indirect systemic risk transmission pathways that aren’t present in other managed asset products. The coupling of ETF share prices with underlying net asset value relies on effective arbitrage by authorized intermediaries or discretionary market-makers; and the current crisis has revealed arbitrage instability and discounts from net asset values in bond ETFs. ETF operational complexity fuels informational opacity in a crisis, and ETF fire sales can drive liquidations in underlying.
As the current crisis has revealed, ETFs are a haven for short-term traders and a hot-bed for new derivatives, and there’s evidence they increase market volatility. I suggest that ETF securities-lending creates multiple risk transmission channels, and if an operational disruption occurred at a large ETF sponsor, investors could shift to quality, triggering selloffs in ETFs and underlying assets, uncertainty in the operations of authorized intermediaries, and significant losses for retail investors, pensions, and corporations.
The Challenge of Regulating Highly Interconnected ETF Sponsors
Regulating highly interconnected ETF sponsors is difficult since they have distinguishing characteristics from banks and insurance companies. ETF sponsors do perform an agency function, with smaller balance sheets, less leverage, substitutable products, and an inability to access central bank liquidity or benefit from government insured deposits. Thus, the largest ETF sponsors were also strong advocates of the Financial Stability Oversight Council’s embrace of an activities-based framework (away from entity-specific) for non-bank systemically important financial institutions.
Activities-based regulation that uses cost-benefit analysis, however, is problematic for unpredictable fast-moving crises and complex, highly interconnected firms with opaque and global operations (like large ETF sponsors). It also doesn’t curb the interconnection-generated risk unique to ETFs. Thus, I lend support to prior studies that consider both activities and entity-based regulation as complementary when addressing financial market systemic risk emanating from non-bank financial firms.
What Are the True Costs of Liquidity Transformation?
When assessing the interconnective influence of large ETF sponsors one must consider the costs of liquidity transformation. Turning opaque, over-the-counter bonds or loans into instantly liquid financial products prompts concerns similar to those involving the mortgage-backed securities and collateralized debt obligations market in the GFC. The Fed providing relief to bond ETFs is reminiscent of bail-outs of the shadow banking and money-market mutual fund industries that also performed liquidity transformation. If government support is a social cost of liquidity transformation, then perhaps, now that the government has entered the ETF arena, firms providing these services should be subject to stronger safeguards.
Despite the current crisis, ETFs retain compelling utility for retail and institutional investors as low-cost diversified investment products. Post-crisis, ETF sponsors will continue to be central to complex financial markets, and their products will be used in future crises as hedging and speculation instruments and be the form of investment for many people’s savings and retirement assets. ETF sponsors may be growing too interconnected to fail, and the most effective regulation may be system-wide framework with broad, implications.
 See Dawn Lim & Mischa Frankl-Duval, In Market Rout, ETFs Are Where The Action Is, The Wall Street Journal (March 15, 2020), https://www.wsj.com/articles/in-market-rout-etfs-are-where-the-action-is-11584270000.
 See Alexandra Scaggs, The Fed Has Never Bought ETFs Before. Here’s Why That’s Changing, Barron’s (March 24, 2020), https://www.barrons.com/articles/why-the-federal-reserve-is-now-buying-etfs-51585076254.
 See Janet L. Yellen, Interconnectedness and Systemic Risk: Lessons From The Financial Crisis and Policy Implications, Remarks at American Economic Association / American Finance Association Joint Luncheon, San Diego, California (January 4, 2013), available at https://www.federalreserve.gov/newsevents/speech/files/Yellen20130104a.pdf.
 See Alan S. Blinder, After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead, at 112-113 (2013).
 See Henry T.C. Hu & John Morley, The SEC and Regulation of Exchange-Traded Funds: A Commendable Start and a Welcome Invitation, 92 S. Cal. L. Rev. 1155 (2019); see also see Henry T.C. Hu & John Morley, A Regulatory Framework For Exchange Traded Funds, 91 S. Cal. L. Rev. 839 (2018).
 See Yesha Yadav, Too-Big-To-Fail Shareholders, 103 Minn. L. Rev. 587, 592-593, 633-636 (2018).
 See Peter Chatwell, The liquidity ‘doom loop’ in bond funds is a threat to the system, Financial Times (March 24, 2020), https://www.ft.com/content/b7c15426-6e1b-11ea-89df-41bea055720b.
 See Marco Pagano, Antonio Sanchez Serrano & Josef Zechner, Can ETFs Contribute To Systemic Risk? Reports of the Advisory Scientific Committee No.9, European Systemic Risk Board (June 2019), 3-4, 28-29, https://www.esrb.europa.eu/pub/pdf/asc/esrb.asc190617_9_canetfscontributesystemicrisk~983ea11870.en.pdf.
 See I. Ben-David, F. Franzoni, F. & R. Moussawi, Do ETFs increase volatility? 73(6) Journal of Finance. 2471 (2018).
 See BlackRock, Letter to Financial Stability Oversight Council, Re: Comments on Proposed Interpretive Guidance, Authority to Require Supervision and Regulation of Certain Nonbank Financial Companies, RIN 4030-AA00 (May 13, 2019), at 47, available at https://www.blackrock.com/corporate/literature/publication/fsoc-interpretive-guidance-supervision-regulation-certain-nonbank-financial-companies-051319.pdf; Vanguard, Letter to Financial Stability Oversight Council, Re: Authority To Require Supervision and Regulation of Certain Nonbank Financial Companies; RIN 4030-AA00 (May 13, 2019), available at https://www.regulations.gov/document?D=FSOC-2019-0001-0013.
 See Jeremy C. Kress, Patricia-Ann McCoy, and Daniel B. Schwarcz, Regulating Entities and Activities: Complementary Approaches to Nonbank Systemic Risk, 92 S. Cal. L. Rev. 1455 (2019).
 See Zoltan Pozsar, Tobias Adrian, Adam Ashcraft, and Hayley Boesky, Shadow Banking, Federal Reserve Bank of New York Staff Report No. 458 (July 2010), 61-64, available at http://ssrn.com/abstract=1645337; Morgan Ricks, The Money Problem: Rethinking Financial Regulation (Chicago: University of Chicago Press, 2016), 96-101.
 Id at 61-64; see William A. Birdthistle, Breaking Bucks in Money Market Funds, 2010 Wis. L. Rev. 1155, 1163, 1190.
 See Morgan Ricks, Regulating Money Creation After The Crisis, 1 Harv. Bus. Rev. 75, 78, 119-120 (2011).
 See Lim & Frankl-Duval, supra note 1.
This post comes to us from Professor Ryan Clements at the University of Calgary Faculty of Law. It is based on his recent article, “Are ETFs Making Some Asset Managers Too Interconnected To Fail?,” forthcoming in the University of Pennsylvania Journal of Business Law and available here.