June 17, 2019

The Advisory Scientific Committee of ESRB published a report presenting the main channels through which exchange-traded funds have the potential to affect systemic risk. The study concludes that, while some of these channels are common to other investment vehicles, their presence on primary and secondary markets, along with the rapid development of the exchange-traded fund sector, warrants further analysis of exchange-traded funds.

The report focuses on the potential systemic risks that may be associated with the spread of exchange-traded funds and highlights the key reasons why exchange-traded funds could pose systemic risks. In addition, the report concludes that exchange-traded funds may raise systemic risk through four main channels:

  • Higher volatility and co-movement of security prices, especially at times of market stress and if the constituent securities are illiquid
  • Decoupling of exchange-traded fund prices from those of constituent securities at times of stress, with destabilizing effects on financial institutions heavily exposed to exchange-traded funds or reliant on them for liquidity management
  • Inducement of investors to take large correlated exposures, which may result in contagion in the event of sharp exchange-traded fund price drops
  • Materialization of operational risks in a major provider of exchange-traded funds, which may generate widespread sales of exchange-traded funds owing to the sector’s very high level of concentration

The report does not discuss specific policy measures, but does call for further empirical research in the following two areas:

  • Exchange-traded fund order flows in periods of stress and their impact on the volatility, co-movement, and illiquidity of both exchange-traded funds and constituent securities
  • The extent to which financial institutions have significant and common exposure to exchange-traded funds and/or rely on them to manage liquidity

 

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Keywords: Europe, EU, Banking, Securities, Systemic Risk, Liquidity Management, Liquidity Risk, Exchange Traded Funds, ESRB

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