ETFs and Systemic Risks

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.