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.
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.
Options being weighed by the commission include tightening rules on the collateral that banks and other firms managing ETFs have to provide when carrying out derivatives trades, the commission said.
The regulator is also considering how to address conflicts of interest that arise when the bank that manages an ETF is also the fund’s counterparty on a derivatives trade, the commission said.
“Shadow banking poses particular challenges for regulators who must address the potential systemic risk posed by entities that undertake bank-like activities” without “undermining the benefits they bring in diversifying risks and supporting economic growth,” said Simon Lewis, chief executive officer of the Association for Financial Markets in Europe,
AFME represents lenders and brokers including Goldman Sachs Group Inc., Bank of America Corp., Deutsche Bank AG and BNP Paribas SA.
Money Market Funds
The Commission will seek views on today’s plans before deciding whether to press ahead with legislation.
Other shadow banks being targeted for new rules include money-market funds and insurers, the commission said.
Barnier said he’s concerned lenders may resort to securitizations, repos and other shadow-banking measures to evade higher capital requirements and limits on bank indebtedness that have been agreed on by global regulators. The measures were drawn up by the Basel Committee on Banking Supervision to prevent a re-run of the financial crisis.
“What we do not want is for financial activities and entities to circumvent existing and foreseen rules,” Barnier said.
One measure known as a “large exposure rule” may be expanded to further limit the amount of business a bank can undertake with any single counterparty, the commission said.
The regulatory crackdown on shadow banking presents “a danger of demonizing activities which could be vitally important in the provision of credit to struggling economies,” Reid said.