Systemic Risks Posed by ETFs

Here is a great report published by Harold Bradley and Robert Litan of the Kauffman Foundation warning about the potential dangers caused by the explosion of ETFs. The authors conclude that the growth in ETFs and ETF derivatives poses more of a systemic danger to the financial system than the advent of high frequency trading. At 84 pages, the report is highly detailed and fairly technical, but definitely worth a read for those interested in learning more about the subject. While I am by no means an expert into the inner workings of the financial markets (at least as it pertains to high speed algorithmic trading), all I could think about as I was reading this report was that we could be facing another October 1987 type-meltdown should regulators continue to ignore the rapid growth in the ETF market.

ETFs have proliferated around the globe at an astounding pace, from roughly ninety at the beginning of this decade to about 450 at the end of 2005 and more than 2,300 today, with another 1,000 or so in the regulatory pipeline (see chart 4).

But there can be too much of a good thing if taken to extremes,and this is now happening with ETFs. From an asset base of about $75 billion a decade ago, ETF assets now approach $1.2 trillion, with trading reaching an astounding $18.2 trillion last year. ETFs have been morphing in new and unexpected ways. Simply put, we will argue here that ETFs and the derivatives built around them have become the proverbial tail that wags the market.

As more ETFs are created, the risk grows that in the event of a future market meltdown triggered by any number of possible causes the rush to unwind the ETFs will aggravate any sell-off. Indeed, some creators of ETFs may not be able to honor their obligations. If those institutions or holders of ETFs are deemed sufficiently important or interdependent with other financial actors, the U.S. government could be forced again to make the agonizing decision whether to come to the rescue, as it did with AIG and a number of other large enterprises during the financial crisis of 2008.