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EU's Lehman-esque problem with synthetic ETFs: this time, don't blame Wall Street!

Londres Plaza / VÍCTOR JIMÉNEZ. 02/05/2011 Today, synthetic exchange-traded funds or ETFs move a capital volume that is four times larger in the self-admittedly wobbly European markets than in the US. But if risk is coming back in earnest, it has already set off the alarms. This time there will be no excuses...

-"Aviso: si los fondos cotizados se vuelven tóxicos, Europa no podrá culpar esta vez a los Estados Unidos"

LONDON. Will we witness an official reaction this May after having appeared the first signs of what could become the European Lehman-esque virus? According to the latest Financial Stability Forum's special report, "the recent rapid growth and innovation in the markets of exchange-traded funds warrants increased attention by regulatory and supervisory authorities, as well as by the exchange-traded fund industry including providers, market-makers and investors."

Nervousness abounds among other global institutions, too, like both the International Monetary Fund and the Bank for International Settlements: exchange traded funds' (ETF) size in the global flows of capital now exceeds one trillion of euros and has registered a 40 per cent in average annual expansion since 2000, with presence in 5,905 listings and 48 exchanges, according to data from BlackRock.

Pension funds and retail investors, believed to be cautious participants in the capital markets' roller coaster, have a high regard for ETFs. There's a reason for that: this type of investment funds track a stock index or fixed rate index, but merely trace them instead of making any purchase of the underlying--that is to say, one may from the regional stock market in Valencia, Barcelona or Bilbao put money into Acción Ibex 35 ETF, which simply follows the Spanish index without, in fact, having bought any bond or shares in a listed company.

Here, diversions begin to emerge and could surely make the markets tumble if taken to the extreme. How? Director of db x-trackers ETF Marco Montanari has explained it in an interview with Risk Magazine: "When trading an EFT linked to an underlying that is not trading, the EFT becomes an independent animal that moves just on the basis of the demand for the EFT, not the underlying."

Besides, matters have turned more complex in the past five years. ETFs have branched out to fixed-income, credit, emerging markets and commodities, and worryingly enough even to derivatives. This is indeed the spark that could ignite the global financial gunpowder again. Synthetic exchange-traded funds have entered a field where, in Financial Stability Forum's words, "liquidity is typically thinner and transparency lower... there are more challenges in terms of counter-party and collateral risks."

In the exchange-traded funds industry in the United States, synthetic ETFs correspond to less than 15 per cent of the total. In the European Union, these reach a heavy 45 per cent, which has led many to ponder that the time has come to switch the brake system on before economic recovery derails.


ETFs' shares are traded and sold daily throughout a daily session in real time on electronic platforms, the Sistema de Interconexión Bursátil Español or Spanish Automated Quotation System in Madrid's case, "with total transparency and liquidity" as indicated by Bolsas y Mercados Españoles (BME), where the grand European banks such as BBVA, Deutsche Bank and Société Générale issue them while smaller institutions such as Banco de Valencia, Bankia or CAM act as intermediaries. Its appeal is obvious to the ordinary investor: fees are smaller than mutual funds' and provide juicier dividends than any mere bank deposit.

In June last year, the Spanish regulator or Comisión Nacional de Mercados de Valores granted ETFs equal regulatory and fiscal treatment with Sicavs (which are similar to US open-ended mutual funds). In 2010, financial transactions related to ETFs on Spanish platforms jumped 83 per cent compared to 2009 and Spain nowadays ranks fifth among countries with the most active sector, a remarkable transformation if one is reminded that BME only opened its doors to ETFs in July 2006.

"The question is: have passively managed ETFs improved efficiency in the markets?" asks professor Thomas Carnevale of St John's University in New York, to what he replies: "In my opinion, the answer should be no. Exchange-traded funds hurt good companies because they must buy and sell shares completely ignoring their fundamentals." Ron Chandler, a partner at BDFunds, thinks otherwise. Chandler states that "through ETFs it's much, much easier to use your money to promote positive progress in our society and economy. There is a growing number of socially responsible and clean energy ETFs."

There might be a bright side about ETFs, but also iShares suggests that "it will be important in the coming years to ensure that new generations of ETFs educate investors on their structures and mechanics when deviate from the traditional ETF as exchanged listed, open-ended, liquid and transparent where the underlying portfolio is disclosed on a daily basis."

The Financial Stability Forum says that the European Union "has a more liberal stance of regulation on use of derivatives in investment funds" than the US, where "retail and institutional investor stake in the sector is better balanced." So the European Commission for Economic and Financial Affairs knows where to start: proving that we have at least learnt some lessons from our 2007 crisis.

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