ETFs and systemic risk

There’s been a slew of articles on the potential for ETF (exchange traded funds) to help fund the next big financial crisis. Naturally, the problems associated with ETFs come from a new breed of more “innovative” structures.

The main problems boil down to two fundamental issues:

• Practically unlimited short selling of shares: For many funds, the number of short-sold shares vastly outnumbers the number of real shares. This is means that the shares sitting in your margin account most likely are not actual shares, but an IOU for shares. Since short-selling gives you cash now, in exchange for the obligation to deliver shares later, there is a risk that banks/individuals are using this as a funding mechanism. No one knows exactly what would happen if there was the equivalent of a “bank run” on an ETF, but my guess is that a lot of holders would find out to their surprise that the shares they hold are not actually redeemable for the underlying.
• Derivative based ETFs: This is particularly nasty and happens more in Europe than in the US. Your ETF isn’t holding actual shares or interest in the underlying, but holds derivate contracts written by various banks in order to simulate this. Naturally, if any of these banks go bust, you are pretty much screwed.

At this point, I’ve given up on ETFs and just own regular old US mutual funds (with a low expense ratio) and plain stock for my foreign content (since the IRS makes it extremely unpleasant to hold non-US mutual funds).