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Mounting concerns over exchange traded funds are shaping up to be one of the first big tests of the tougher regulatory environment in the wake of the financial crisis.

In the 22 years since the first ETF was launched, this line of investment products has accumulated many of the hallmarks of both a runaway success and a potential danger to investors and financial stability — rapid growth, increasing complexity and broader marketing.

The challenge for regulators will be to defang the threat without killing off or severely curtailing a thriving market, a complex balancing act at the best of times. Further complicating the task is that many of the police are new to the beat and still getting to grips with their powers.

Though the first ETF was created in 1989 and 1990 as a simple basket of stocks that tracked popular indices and could be bought and sold throughout the day, the products have expanded and morphed beyond all recognition. Today, ETFs, notes and commodities, collectively known as exchange traded products, do everything from tracking the price of gold or copper, to providing the inverse of the return on the Standard & Poor’s 500, the world’s most widely tracked index. At the end of June 2011, 184 providers were running nearly 4,000 separate ETPs with more than $1,600bn in assets.

“We have identified a potential risk and this may become an important issue in the future,” says Edouard Vieillefond, managing director for regulation and international affairs at the Autorité des Marchés Financiers, the French regulator. “Like any product, there is a tendency to go towards more and more complexity and a wider and wider audience, and that is where things can go wrong.”

According to Lyxor, one of Europe’s largest providers, turnover of European on-exchange ETPs equalled 14 per cent of equivalent equity market activity at the end of September, significantly higher than last September’s figure of 8 per cent and nearly four times the levels in 2008.

ETFs have prompted warnings from both traditional securities regulators such as the AMF and the US Securities and Exchange Commission and several of the newly created bodies charged with spotting and damping down threats to the broader market, including the European Systemic Risk Board and the UK Financial Policy Committee.

Both sets of watchdogs are particularly focused on the subset of ETFs and ETPs known as “synthetics” because this product relies on swaps and futures to provide promised returns rather than holding actual gold, shares or bonds. They believe that investors need to be better informed about how closely the derivatives mimic the desired index and the counterparty risks involved.

There is also great concern about the quality and amount of collateral that ETFs receive as insurance against the derivative provider going bust. The risk regulators, in particular, are worried that the banks involved are essentially using ETFs as a source of short-term funding and are handing over collateral that could prove hard to sell in a volatile market. That could in turn make the provider bank vulnerable to losses of confidence or even a run on liquidity such as the one that took down Lehman Brothers, the US investment bank.

“Specific forms of ETFs, such as synthetic ETFs, deserve more scrutiny from the stability point of view. This holds especially for the issue of proper collateral arrangements when ETFs are involved in securities lending and when they are engineered on the basis of derivatives,” Steven Maijoor, chairman of the European Securities and Markets Authority (Esma), the new pan-European Union securities regulator, said recently.

One of Esma’s early actions after coming into existence this year was to open a consultation on ETFs and whether new rules were needed to “mitigate the risk “ around selling complex products to retail investors.

Esma has suggested that it might create a special “complex” designation to segregate synthetic ETFs from other funds sold under the Ucits label that the EU uses for products aimed at retail investors. Some providers now fear that regulation of synthetic ETFs is not only inevitable but could well sweep in absolute return bond funds and other funds that use derivatives in their efforts to generate results.

“Generally, complexity does not give a good indication of appropriateness for investors,” Deutsche Bank, one of Europe’s largest providers of synthetic ETFs, wrote to Esma in its response to the consultation. “After all, if a product embeds a derivative, in many cases it is intended to reduce risk.”

US regulators have put in place a moratorium on new derivatives-based products while they study the problem.

On the prudential side, it is less clear what the regulators will do. While they have warned about potential problems with liquidity and collateral, no one knows how big these issues really are.

“It’s the first example of the new macrostability apparatus in action. Some of the concerns may potentially be overblown. What we desperately need quickly are data and facts,” said David Strachan, who co-heads the centre for regulatory strategy at Deloitte, the professional services firm.

ETF providers and analysts say that some of the concerns are overblown.

“Central banks have to worry about stability, but to chose something that is very visible and makes more information available [than competing products] does it a disservice,” Christos Costandinides, head of ETF research at Deutsche Bank, told a conference on the products recently.

EFT providers also point out that the collateral issue may not be universal. Ireland and Luxembourg, where many ETFs are domiciled, have much tighter rules on collateral than Switzerland and the Channel Islands, they say.

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