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The growth of exchange-traded funds (ETFs) has raised questions about their effect on market stability. This publication examines the impact of ETFs on the financial system and proposes regulatory actions to mitigate risks.


ETFs and Systemic Risks

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Overview

Exchange-traded funds (ETFs) revolutionized asset markets by using an innovative structure to make investing in a wide variety of asset classes simpler and cheaper. With their growing importance has come increasing concern that these products pose new risks to market stability and performance. This paper examines whether ETFs affect systemic risks in financial markets and, if they do, what the mechanism is by which this impact occurs and what can be done to keep the risks under control. We review current research and empirical evidence on these issues and discuss some emerging risks in ETFs. We ask whether we have the right “rules of the road” to deal with the new drivers of market behavior.

Summary

Exchange-traded funds (ETFs) revolutionized asset markets by using an innovative structure to make investing in a wide variety of asset classes simpler and cheaper. When first introduced, ETFs were viewed as a sideshow in the market, but their spectacular growth, combined with recent episodes of market instability, raises troubling concerns that these products may now pose new risks to market stability and performance. But are ETFs actually the culprit in destabilizing market dynamics, or are they merely innocent bystanders in today’s complex market environment?

This paper examines whether ETFs affect systemic risks in financial markets and, if they do, what the mechanism is by which this impact occurs. We review current research and empirical evidence on these issues and discuss some of the systemic risks that may relate to ETFs’ particular design. Among the issues considered are the impacts of ETFs on market close, the problems raised by underlying asset illiquidity, market concentration at various levels of the ETF food chain, and step-away risks from authorized participants. We compare various tools a regulator can use to deal with these potential systemic effects, as well as some current regulatory initiatives. We draw attention to several emerging risks, such as those arising from the increased use of ETFs as cash substitutes.

We conclude that ETFs can be a source of systemic risk, in large part because these assets can induce important feedback effects in markets. We also conclude that these effects can be greatly mitigated by careful regulatory oversight and identify various actions one can take to keep the risks under control. Our paper raises the intriguing question of whether we have the right “rules of the road” to deal with the new drivers of market behavior.

About the Author(s)

Maureen O'Hara
Maureen O’Hara

Maureen O’Hara is the Robert W. Purcell Professor of Finance at Cornell University’s Johnson Graduate School of Management. She is an expert on market microstructure and publishes widely on banking and financial intermediaries, law and finance, and experimental economics. Professor O’Hara is the author of numerous journal articles, as well as the books Market Microstructure Theory; High-Frequency Trading: New Realities for Traders, Markets, and Regulators; and Something for Nothing: Arbitrage and Ethics on Wall Street. She has served as president of the American Finance Association, the Western Finance Association, and the Financial Management Association and as executive editor of the Review of Financial Studies. Professor O’Hara was a member of the CFTC-SEC Emerging Regulatory Issues Task Force (the “flash crash” committee) and served on the Global Advisory Board of the Securities Exchange Board of India, the Advisory Board of the US Treasury’s Office of Financial Research, and the SEC’s Equity Market Structure Advisory Committee. She was named to Institutional Investor’s Trading Technology Top 40 and is a fellow of the Initiative for Cryptocurrencies and Contracts. Professor O’Hara is an adviser to Symbiont, a company focusing on blockchain and smart securities, and AVA Labs, a cryptocurrency and blockchain startup.

Ayan Bhattacharya

Ayan Bhattacharya is at the Bert W. Wasserman Department of Economics and Finance, Zicklin School of Business, Baruch College, The City University of New York, New York, NY.

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