Exchange-traded funds targeted in EU shadow-bank clampdown

March 19 (Bloomberg) -- Exchange-traded funds may face tougher regulation of derivatives trades as part of a European Union clampdown on so-called shadow banks that could pose a threat to the region’s financial system.

The European Commission said today that it is examining potential “conflicts of interest” affecting ETFs, a type of fund that tracks an index and whose shares are publicly traded. The regulator is also reviewing whether banks and other financial firms are using so-called repurchase agreements, or repos, to build up excessive levels of debt.

Regulators will not allow “new sources of risk to accumulate in the financial sector,” Michel Barnier, the EU’s financial-services chief, said in an e-mailed statement.

While financial watchdogs have reined in excessive risk taking by banks in the wake of the collapse of Lehman Brothers Holdings Inc. in 2008, they are concerned that lenders and other financial firms can use ETFs, repos and other off-balance sheet activities to evade the rules.

Adair Turner, chairman of the U.K. Financial Services Authority, said last week that shadow banking is “potentially very unstable” and vulnerable to liquidity shocks. Supervisors shouldn’t allow “complex interconnectivity” and “high leverage to develop in unregulated institutions or markets,” he said. The shadow banking industry in Europe is worth $22 trillion, and $25 trillion in the U.S., by some estimates, Turner said.

‘Relative Opacity’

The Financial Stability Board, which brings together G-20 regulators, central bankers and finance ministry officials, said last year that ETFs may “generate new types of risks, linked to the complexity and relative opacity of the newest breed” of funds.

The global ETF industry had $1.2 trillion of assets under management at the end of September 2010, according to the FSB. While the U.S. remains the largest market in terms of assets, the number of ETFs listed in Europe surpassed the U.S. in April 2009, according to data from BlackRock Inc. Some so-called synthetic ETFs use derivatives to track an index’s movements.

“We’ve seen a dramatic rise in the role of ETFs in recent years and of course this causes regulators’ warning bells to start ringing,” Richard Reid, research director for the London- based International Centre for Financial Regulation, said in an e-mail. Still, such funds can “provide investors with much needed access to financial markets,” he said.

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