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Are $1.4 Trillion ETFs The New WMDs? Anatomy Of Highly Toxic UBS Scandal

Stock-Markets / Exchange Traded Funds Sep 19, 2011 - 02:41 AM GMT

By: DK_Matai

Stock-Markets

Best Financial Markets Analysis ArticleWe have mounted an investigation into the role of Exchange Traded Funds (ETFs) linked to the $2 billion black hole at UBS. We have uncovered a complex entangled world wide web of $1.4 trillion including derivative exposures and counterparty risks.


Extreme Perils of Exchange Traded Funds (ETFs), Derivatives and Unlimited Black Swans (UBS)

Exchange-traded funds are back under the spotlight because of their connection with the alleged $2bn "rogue trader" scandal at UBS's Delta One ETF operation. No one who truly understands the technical makeup of these financial instruments is surprised to see the words ETF and rogue trader in the same sentence! However, purveyors who believe that ETFs are good enough financial "assets" for "widows and orphans" act clueless and some feign total surprise.

Financial Stability Threatened

Regulators around the world have expressed concern that ETFs might be a new source of market instability for nearly a year now.

1. America's Securities and Exchange Commission (SEC) has launched a probe this week into whether ETFs are contributing to market volatility by offering investors a way to quickly lift and reduce their exposure to the financial markets. This, in turn, forces large entries and exits from the underlying securities, or derivatives, that mirror the assets or asset class that the ETFs seek to track.

2. The Bank of England warned in June 2011 that ETFs are potentially dangerous for unsophisticated investors. The rogue trading event that hit Societe Generale in 2008 also originated on a desk that was buying on the market to compile portfolios that underpinned ETFs. The UK's new Financial Policy Committee (FPC) has warned that ETFs are shrouded in "opacity and complexity". It said it was concerned that ETFs "could become a source of risk to the system as the market evolves".

3. The Financial Stability Board (FSB), an international super-regulator based at the Bank for International Settlements in Basel, Switzerland, wrote a prescient paper "Potential financial stability issues arising from recent trends in Exchange Traded Funds (ETFs)" in April 2011. Its central warning was that ETFs are neither cheap nor transparent.

What are ETFs?

ETFs are listed securities that mirror various assets or asset classes, including shares, market sectors, indices, commodities, fixed-interest securities and their sectors.

How big are ETFs?

The ETF market is growing rapidly. It was relatively minor on the financial landscape when the new century began, with investments of just $74.3 billion, all of it in equities. ETFs grew to $797 billion in 2007 when the global financial crisis erupted, and passed $1 trillion in 2010. BlackRock, the US-based asset manager that owns the biggest ETF provider, iShares, estimates that ETF assets totalled $1.4 trillion on 49 global exchanges by June 30, 2011, and forecasts that their total will pass $2 trillion in 2012.

Popularity

The last decade saw an explosion in the popularity of ETFs because of their well known benefits:

1. Relatively low costs; 2. Buying and selling flexibility including the capacity to trade them throughout the day; 3. Tax efficiency including favoured status by tax regimes; 4. Market exposure and diversification; and 5. Implied transparency.

Majority of ETFs are traded by institutional investors and hedge funds. Acceleration in growth of ETFs is linked to their presence on superannuation and other retail investment platforms in the secondary market. It is often incorrectly claimed that ETFs are simple products. Once upon a time, this was true. Now, this argument no longer holds water. Many ETFs are extremely complex and simply beyond the comprehension of individual investors and professionals alike.

Derivatives

Some ETFs do not hold physical assets of the sort they seek to track. They are "synthetic" and hold derivatives. For example, around half of the ETFs in Europe today do not match the index they are designed to track by holding all of its constituent shares. Unlike the plain vanilla "full replication" old ETFs which used to do so, nearly half of the new market is in the form of so-called "swap-based" ETFs which instead use derivative agreements, often with investment banks, to simulate the performance of the underlying assets. When an ETF security is bought, the investment bank or funds management group that is selling the ETF buys corresponding exposure, to pair the ETF's performance with the assets it is tracking. This is sometimes done by purchasing the physical asset -- shares or a share index -- but as the industry has grown it has become increasingly common for ETF vendors to take the exposure by buying derivatives, and to also use derivatives to insure against unwanted extraneous market movements.

Leveraged ETFs

Leveraged ETFs are a special type of ETF that attempt to achieve returns that are more sensitive to market movements than non-leveraged ETFs. They require the use of financial engineering techniques, including the use of equity swaps, derivatives and rebalancing to achieve the desired return. The most common way to construct leveraged ETFs is by trading futures contracts. The rebalancing of leveraged ETFs may have considerable costs when markets are volatile and can lead to substantial losses.

Counterparty Risks

The derivative-based make-up of ETFs gives rise to counterparty risks. As we saw with the UBS incident, some interesting risks arise within the counterparties supplying the basket of derivatives. What happens if such ETF trades cause such a mammoth loss in a counterparty that it does not have sufficient capital to bear the loss and pay out under the derivative contract? Answer: The ETF fails, leading to massive counterparty losses! ETFs based on derivative trades add a second layer of uncertainty to the unavoidable sudden ups and downs of the market and include the counterparty risks that may cause the organisation on the other side of the contract to go bust. This toxic aspect of ETFs is unclear to most investors in ETFs, who treat these complex financial instruments as if they were as safe as equities and bonds.

Conflict of Interest

Unbeknownst to the investor, the provider of the ETF might sometimes be a part of the same organisation as the derivatives desk carrying out the swap. When a financial institution acts in this dual capacity -- given the inadequate disclosure rules -- there is a significant potential for a conflict of interest in which the end investor comes off second best. There is currently no obligation for the basket of assets used as collateral to actually match the assets the ETF purports to be tracking. Hence a bank may choose to hold less liquid assets to back the fund which it could struggle to sell if too many investors want to exit at the same time. Think of all the gold ETFs and then ask yourself: How much physical gold actually underpins the gold ETFs? Answer: Not a lot! As much as half of the trades in gold are now driven by ETFs, while some blame them for speculatively driving up food prices.

Volatility, De-Coupling and High Risk

Extreme volatility makes ETFs behave unpredictably. ETFs do NOT always match the underlying asset or asset class in the way investors expect. Given the daily rebalancing and compounding, an investor can own a leveraged long ETF and end up losing money over a period when the market goes up but during which there are some sharp falls. Equally, an investor can own an inverse ETF -- which provides a short exposure -- during a period when the market goes down but if there are some sharp rallies, the investor ends up losing money. This actually occurred with some inverse ETFs in 2008, for example. ETF investors would not normally expect to be leveraged long and lose money if the market goes up or be leveraged short and lose money when it goes down. Yet, this is entirely possible with ETFs and is not known as an outcome to most investors.

Massive Short and Long Positions: High Frequency Trading (HFTs)

A big unrecognised risk with ETFs is related to the ease with which traders -- hedge funds and High Frequency Traders (HFTs) in particular -- are able to use such funds to short markets or go long. It is technically possible for the number of shares sold short or long in an ETF to exceed the actual number of shares available massively! It has been suggested that the "Flash Crash" of May 2010, in which US shares fell 1,000 points before bouncing back in a matter of minutes, was a consequence of this: around 70 percent of cancelled trades at the time were reported to be for ETFs by High Frequency Traders (HFTs). Given that hedge funds and financial institutions can apparently rely upon creating the units to deliver on their short, some market participants are short 1,000% or 10 times the amount of the ETF available. The danger of allowing short sales which are a multiple of the value of a fund in an area where it may not be possible to close the trades by buying back the stocks are clear. Yet, purveyors of ETFs claim that there is no such risk in shorting ETFs. Do they not understand the product they are offering, and if they can't, what chance has the retail investor got?

Camouflage and Subterfuge: Insider Trading

ETF stripping allows virtually untraceable insider trading. The way this works is that rather than take a position in a security where someone has inside information, The trader buys or sells the ETF and does the opposite on all the stocks that make-up the ETF, except the one for which they have insider knowledge.

Liquidity Out Of Thin Air

The problem of liquidity is an increasing issue with ETFs because of the way in which the funds have branched out into other asset classes such as fixed income and commodities including gold and oil. In these markets, liquidity is typically thinner than in big equity markets such as those measured by global indices like the S&P 500 or the Dow Jones. Liquidity is only ever a problem at times of market stress. Unfortunately, that is precisely the time when it matters, as Mortgage-Backed-Asset (MBA) investors discovered a few years back when the property market turned down and their managers were unable to sell enough properties to pay back redeeming unit holders. Investors were locked in. If the ETF is in an illiquid sector, can one really rely upon creating the units as one may not be able to buy (or sell) the underlying assets in a sector with limited liquidity?

Undisclosed Profitability

Although ETFs are billed as low cost they are also the most profitable asset management product for a number of providers. How can this apparent contradiction exist? The answer is that the charge for managing the ETF is only one part of the cost. There are also hidden cost benefits in the synthetic and derivative trades which the provider undertakes for the ETF.

Mis-selling

There is a rising possibility that ETFs are being mis-sold to the retail market and risks are being incurred in running, constructing, trading and holding them, that are not sufficiently understood. After the UBS incident, this mis-selling of ETFs might become indisputable.

Conclusion

1. Exchange Traded Funds (ETFs) have in a remarkably brief space of time become a trillion-dollar plus trading instrument with critics of ETFs arguing that they represent short-term speculation, that their trading expenses decrease returns to investors, and that most ETFs provide insufficient diversification.

2. The latest UBS black hole is likely to have repercussions, because it has occurred in the ETF sector, a part of the market that is rapidly becoming system-critical. The sudden loss of $2bn at UBS ought to remind investors of the pitfalls of these derivative-based instruments. It is likely that there will be moves to increase oversight of the ETF market in the wake of the UBS scandal. Are regulators going to slam the ETF barn door after the horse has long bolted?

3. Like many financial innovations -- such as the mortgage-related debt obligations that triggered the global financial crisis in August 2007 -- ETFs started out as a good idea. For some investors, in their most transparent form, they remain so. Now, a tangled web of complexity has rapidly developed. What was once a straight-forward means of gaining access to a market has turned into a minefield for investors and one which, as UBS discovered, has the potential to become the next toxic scandal!

4. Some critics claim that ETFs can be, and have been, used to manipulate market prices, including having been used for short selling that has been asserted by some observers to have contributed to the market collapse of 2008 and other severe market corrections.

5. Investors in Exchange Traded Funds (ETFs) ought to review each of the ETFs in which they are invested to reassess the true content and degree of risk embodied in them.

What are your thoughts, observations and views? We are hosting an Expert roundtable on this issue at ATCA 24/7 on Yammer.

By DK Matai

www.mi2g.net

Asymmetric Threats Contingency Alliance (ATCA) & The Philanthropia

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ATCA: The Asymmetric Threats Contingency Alliance is a philanthropic expert initiative founded in 2001 to resolve complex global challenges through collective Socratic dialogue and joint executive action to build a wisdom based global economy. Adhering to the doctrine of non-violence, ATCA addresses asymmetric threats and social opportunities arising from climate chaos and the environment; radical poverty and microfinance; geo-politics and energy; organised crime & extremism; advanced technologies -- bio, info, nano, robo & AI; demographic skews and resource shortages; pandemics; financial systems and systemic risk; as well as transhumanism and ethics. Present membership of ATCA is by invitation only and has over 5,000 distinguished members from over 120 countries: including 1,000 Parliamentarians; 1,500 Chairmen and CEOs of corporations; 1,000 Heads of NGOs; 750 Directors at Academic Centres of Excellence; 500 Inventors and Original thinkers; as well as 250 Editors-in-Chief of major media.

The Philanthropia, founded in 2005, brings together over 1,000 leading individual and private philanthropists, family offices, foundations, private banks, non-governmental organisations and specialist advisors to address complex global challenges such as countering climate chaos, reducing radical poverty and developing global leadership for the younger generation through the appliance of science and technology, leveraging acumen and finance, as well as encouraging collaboration with a strong commitment to ethics. Philanthropia emphasises multi-faith spiritual values: introspection, healthy living and ecology. Philanthropia Targets: Countering climate chaos and carbon neutrality; Eliminating radical poverty -- through micro-credit schemes, empowerment of women and more responsible capitalism; Leadership for the Younger Generation; and Corporate and social responsibility.

© 2011 Copyright DK Matai - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


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