The growth of the exchange traded fund (ETF) market poses a risk to financial stability, according to Andrew Bailey, chief executive of the Financial Conduct Authority (FCA).
Mr Bailey was speaking at London Business School on 26 April, where he said the growth of the ETF market has been substantial in recent years, and the liquidity of many of the products in times of severe market trauma is untested.
“The secondary market liquidity of ETF shares is dependent on market makers and authorised participants (APs).
"We know relatively little – as we have not experienced a stress since this structure grew so rapidly – about the capacity and willingness of APs to execute their function in stressed conditions where they may be under pressure to tighten their own risk limits.
"The result could be unexpectedly large discounts for ETF investors selling their holdings relative to the estimated value of the underlying assets, and possibly a need to suspend fund dealings.
"As with open-ended funds, this could have the potential to amplify shocks to market conditions which are already under stress.
"We have no easy way of sizing this risk, but we cannot ignore its potential given the rapid growth of ETFs.”
He compared the potential for a liquidity problem to emerge in the ETF market to the closing of some open-ended property funds to redemptions in the immediate aftermath of EU referendum.
Those funds restricted the ability of investors to take their money out because the pace of demand for redemptions exceeded the ability of the funds to raise the cash by selling physical property assets, which are relatively illiquid.
Mr Bailey said that for both open-ended actively managed funds and for ETFs, product providers must be careful to ensure that they are not promising investors they can withdraw their cash at a day’s notice, when this may not be feasible.
Adam Laird, head of ETF strategy for Northern Europe at Lyxor, a firm specialising in the investments, said liquidity risk is something ETF providers take seriously.
He highlighted the growth of ETFs trading in high yield bonds as an area where liquidity could be a problem in times of severe stress.
But he rejected the comparison with commercial property funds, saying it takes months to sell a property and there are considerable tax implications to selling such assets, all of which hinders liquidity.
Mr Bailey also said he shares the industry’s concerns about the implementation of the Packaged Retail Investment and Insurance Products (PRIIPS) rules.
Mr Bailey said the FCA continues to engage with the industry and regulators on these matters, but he stopped short of making any commitment to change anything.