AFTER A CAREER spanning some 35 years in the City, I have developed a nice little network of what I refer to as low friends in high places. So it came, about a year and a half ago, that a chum of mine who is in a position of responsibility with one of the regulators asked me out for a coffee.
We settled down to a Turkish coffee at a joint close to our offices and it was there that he asked the critical question: “What is the headline we don’t want to see in the press?” In other words, he was asking me where I saw the next crisis developing and hence where would it be that his agency should be focusing its efforts.
What most of us have clocked by now is that the tighter regulatory framework that has emerged over the past five or six years has focused almost entirely on the banks. But by focusing so intently on the banks there is a good chance that the regulators are preparing to fight the last war.
The real worry has to be in the space occupied by exchange traded funds. The growth in the ETF market has been eye-watering and, as with structured products before the financial crisis, new variations are popping up on a more or less daily basis. Soon there will be no form of investment that cannot be put together in an ETF portfolio. As one analyst pointed out to me, private individuals can now build their own hedge fund as there are leveraged ETFs and short ETFs in just about any product in which money can be made or lost.
The problem, however, remains the same as in synthetic CDOs – the entire complex is built in derivatives and as clever as they are and as much as the tail wags the dog when times are good, if something in the market goes wrong and traffic in the underlying ceases, then the derivatives go down the pan. A market without a bid is a lot more painful in derivatives than it is in the underlying cash product. This is where that term “liquidity mismatch” re-emerges. ETFs look and behave as though they are so much more liquid than the underlying but that has to be questioned.
A market without a bid is a lot more painful in derivatives than it is in the underlying cash product
I HAVE READ all the blurb about how robust the structures are and how nothing serious can ever go wrong – in the same way in which, in 1991, we were reassured that Mrs Watanabe would continue to buy Japanese equities and that 39,000 on the Nikkei was just a staging post on the way to the moon, not to mention how credit conduits and SIVs were bullet proof with their Triple A ratings and endless cheap CP funding.
Yes, just like the last time, this time it will be different.
Don’t get me wrong. I hold ETFs in my own investment portfolio and use them for the purpose for which they are best suited, namely to gain exposure to major indices such as the S&P and Dax, which I could otherwise not easily replicate any other way. There are, however, many, many different ETF structures and to regard them, speak about them or regulate them as a generic product is not clever.
I wrote recently about the time of the German Riester plans when products had to be principal protected. On a principal protected fund of hedge fund structure the hedge fund takes two and 20, the fund of funds takes two and 20 and the provider of the principal protection takes around 4%. The structurer had to be fed, as did the salesman and the custodian … so may people making such a good living. ETFs have rather less layers but I’m sure the likes of BlackRock are not in the game for the benefit of the end-user.
THE ECONOMIST RECENTLY carried an article in which it tried to explain why ETFs were totally sound. Really? I suppose if the Economist believes it, it must be true. I do, however, remember the same publication writing on what was then the newly developing CDS market and crowing that the risk to banks’ balance sheets was now dispelled and confined to history because they could all cheaply and easily hedge themselves against defaults.
No doubt IFR wrote something similar. But if a borrower defaults, somebody loses the money, whether it is the bank or somebody else. The largest part of the global financial crisis was brought about by nobody being able to nail down who that somebody was – and exposure through ETFs does not make the world any more transparent.
Thus, if my regulatory chum were to ask me which headline would be the one they would not want to see it would be: “Regulators once again don’t know where the bodies are buried”.
