FT Alphaville " ETFs, unregulated banks in disguise If one article sums up how ETFs have come to change the market structure of the equity universe, it's this one from Paul Amery at Index Universe on Thursday. As he recounts, the thing that really worries regulators is the role ETFs play in the shadow banking world today. To what degree do their security deposits fund banks, and what sorts of maturity transformation is going on behind the scenes? Also, to what degree do ETF providers fulfil a credit intermediation role by transferring capital and liquidity from savers to borrowers, even when most ETF investors are unaware of the fact that their "deposits" may not be fully capitalised at all times? Amery refers a lot to this speech by the Paul Tucker, in which the Bank of England deputy governor reflects openly on the changing role of credit intermediation: "Shadow banking," said Tucker, "is credit intermediation, involving leverage and maturity transformation, that occurs outside or partly outside the banking system." Credit intermediation by non-banks is not, in itself, a bad thing, said Tucker, a point that Michel Barnier, European Commissioner for the internal market and services, and several other conference speakers were also keen to stress. But the fact that shadow banking structures are able to do what banks do - that is, to take deposits and lend out a multiple of that deposit base, or to raise funding in the short-term markets and lend longer-term - means that they require extra supervision, Tucker argued. Interestingly, while a lot of attention has been paid to synthetic funds, which exploit the funding potential of ETFs in a much more obvious fashion (even though they themselves are hugely opaque about how they do it... the point is we know they're doing it), funds that focus on securities lending and repo to supplement official income have drawn less scrutiny. But Amery's analysis questions whether this is fair given that much of the cash physical funds receive from lending operations is usually reinvested either into higher yielding investments or ones with completely different maturity profiles. What's more, ETF investors are usually unaware of when their money is being recycled in this way. As Amery highlights from Tucker's speech: "Anyone holding a securities portfolio can build themselves a shadow bank using the securities lending and repo markets," Tucker pointed out. One simply lends out the securities at call for cash, and then one employs that cash by making loans or buying credit-assets with a longer maturity. This is leverage and maturity mismatch. The risk therefore doesn't lie so much with the counterparty you're lending your securities to, but with how you invest the cash/bond collateral you receive in return. Actions which those funding you are not usually privy to. The securities lending operations in effect come to facilitate the monetisation of the assets held by the funds. Which is why the sooner regulators realise that "ETF investments" are no different to uninsured deposits - because ETFs basically behave as giant silos of fully capitalised equity/bonds/commodity stock, which banks exploit in exactly the same manner that they exploit deposits - the sooner ETFs can be regulated the same way that banks are. The industry unsurprisingly hasn't taken kindly to this view, according to Amery. But their defence is weak to say the least. Take this retort from Alain Dubois, chairman of Lyxor Asset Management and co-panellist on the conference's ETF session: "Funds may be regarded as banks," said Dubois, "but if they are banks they are starting from a base of 100 percent capital backing." This, to us, is a non-sensical statement. Hasn't the core banking model - even back in the days of the Medici - always started with 100 percent capital backing which is then leveraged up? Isn't that the whole point of banking? Clearly, we're missing something. Or perhaps banking has got so convoluted along the way that bankers have forgotten this intrinsic fact. Related links: Shadow Banking Probe Encompasses ETFs - Index Universe Shadow banking: thoughts for a possible policy agenda - BoE Just like a giant secured loan to commodity producers... - FT Alphaville Do banks see ETFs as inexpensive funding for illiquid securities? - FT Alphaville This entry was posted by Izabella Kaminska on Thursday, May 3rd, 2012 at 16:34 and is filed under Capital markets. Tagged with bank of england, etfs, paul tucker, repo, securities lending, shadow banks.