- The risk of liquidity disruptions;
- Collateral quality in securities lending and swaps transactions; and
- Conflicts of interest when counterparties are part of the same group.
The European Banking Authority (EBA) has addressed these concerns in an Opinion addressed to national supervisory authorities that was issued this month and outlines Good Practices regarding the management by banks of keys risks from their ETF business or when dealing with ETFs.
The Opinion considers the importance of ETFs as a source of financing and liquidity for the banking group and the liquidity risks associated with sudden withdrawals from ETFs. A bank's treasury function will need to ensure that it has complete visibility of the ETF business and properly assess ETF liquidity to define the size of required liquidity cushions.
Each banking group should ensure that they have a thorough understanding of the nature and extent of ETF counterparty exposure and receive adequate information from ETFs on the use of complex strategies, derivatives and securities lending.
As part of their risk management practices banks will need to assess the quality of ETF direct investments and collateral, and integrate any re-hypothecation practices and counterparty concentration limits into their risk management of ETF activities.
The EBA Opinion emphasises the need for proper internal reporting and risk management procedures to capture all the relevant risks. In terms of governance, banking groups will need to ensure that they have robust governance policies in place to avoid conflicts of interests within a financial group that may act simultaneously as ETF provider, swap/securities lending counterparty, authorized participant/market maker or investor on their own account.
In parallel to the EBA Opinion, the European Securities and Markets Authority (ESMA) guidelines on UCITS ETFs came into force in the EU in mid-February and tackle many of these risks by tightening the product rules for all ETFs that operate under UCITS.
Banks should carefully consider the ESMA rules when evaluating the risks of UCITS ETFs versus non-UCITS ETFs and tailor their risk management procedures accordingly – although in practice it is likely to be too early for UCITS to be fully compliant with the new ESMA framework.
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