September 2011

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Along with their growing popularity, exchange-traded funds (ETFs) are seen as potentially dangerous derivative instruments in financial markets by some regulators and observers. Recent white papers on ETF risk and subsequent press articles have been well intentioned although some have suffered from errors or important omissions.

In this report, Finadium evaluates white papers from six major international regulators that have framed recent conversations about ETF risk in securities lending and derivatives. Supported by conversations with ETF sponsors, market makers, securities lending specialists and service providers, we analyze ETF collateral holdings, short selling and short interest data to assess the validity of popular concerns with a focus on collateral illiquidity. Lastly, we consider the importance of securities lending revenues to ETF sponsors including the rationale of asset managers for engaging in lending.

Securities lending and derivatives can be used safely by ETFs or can destabilize a financial environment; much depends on the risk management practices that underlie their operations. Likewise, ETFs will be affected by broader market trends that disrupt the securities lending and collateral markets. Our review highlights the connections between ETFs and other market activities to examine the risks involved and potential areas for mitigation. By offering more information and accountability to investors and regulators, ETF providers themselves will be the biggest beneficiaries in the long run.

This report is 36 pages with 7 exhibits.
■ Executive Summary

■ Why Worry About ETFs?
– Methodology

■ The Mechanics of ETFs in Securities Lending and Derivatives
– Securities Lending
– Derivatives

■ Notices and Reports from Regulators
– The First Wave: Concern for Retail Investors
– The Second Wave: ETFs and Derivative Risk Management
– The Third Wave: ETFs and Systematic Risk
– ETF Regulation in Europe

■ ETFs and Fails to Deliver in the US Markets

■ Derivative-based ETFs and Collateral Management
– Lending Securities from the Collateral Pool

■ Towards a More Optimal ETF Market Structure

■ About the Author

■ About Finadium


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