ETFs: Investigation on the Possible Threats to Financial Stability

Abstract

New financial regulations and a re-shaping of the market landscape are pushing investors’ interest towards passive investment vehicles. In particular, exchange traded funds have experienced the fastest growth among these latter in the recent years. Thanks to their unique characteristics, these instruments have boosted the democratization of financial markets and have created new opportunities for portfolio construction widening the range of securities any individual with a brokerage account can invest in. Many concerns arose though, regarding the risks ETFs might represent to financial stability. There are evidences that ETFs, through their creation and redemption mechanics and intrinsic arbitrage activity, are influencing the values of their underlying portfolios creating new channels for shocks propagation. In this work, I am going to conduct a thorough analysis of this relatively new dynamic industry, investigating the pros and cons they represent for the financial system as a whole and the triggers for the next financial crisis. The first chapter will introduce the reader to the ETFs world providing important information about size and development of this sector and ETFs characteristics, usage and mechanics. In the second chapter, ETFs activity will be analyzed and the consequences their usage is having on their components will be brought out of the shadows. I will describe the empirical evidences and important discoveries of this influence and I will show how ETFs can and have contributed to shock. Finally, I will talk about the regulatory evolution of the industry and how regulators are trying to increase its transparency, focusing mostly on the MiFID II implementation in Europe.