The rapid growth in ETFs is leaving our financial markets more exposed.
That’s the view of Ian Russell, president and CEO of the Investment Industry Association of Canada
, who believes capital markets face a three-pronged threat: market fragmentation, the shortage of liquidity and the potential for sudden shock, like geo-political events or an inability to deal with cyber-attacks because of outsourcing.
He said the key to protecting against these was better regulatory co-ordination between the markets and cross-border jurisdictions.
Addressing an Empire Club of Canada audience at the IIAC’s Annual Investment Outlook Luncheon, Russell said the growing popularity of investors putting money in diversified index funds and “buying the market rather than individual companies” to reduce costs increases exposure to sudden declines.
ETFs now make up one-quarter of US stock trading volume – five years ago it was only one-sixth - and three-quarters of traded single stocks.
He said: “The large, concentrated holdings of index-linked products and mutual funds in individual and institutional portfolios are vulnerable to asset price declines synchronised right across the market and highly exposed to external shocks from macro factors, such as rising interest rates, change in monetary policy, or major geo-political events.”
He added: “The potential is there for an unprecedented herd mentality, leaving market-makers with limited scope to absorb panic selling.”
Meanwhile, cyber-attacks are becoming increasing sophisticated and Russell believes “firms’ standards of financial integrity and cyber security may not be matched by these third-party vendors”.
With regards to market fragmentation, Russell said regulators’ failure to co-ordinate rule-making has led to duplication and an overlap with transactions, leaving derivative traders struggling to deal efficiently with foreign counterparties. He added that the rise of protectionism in the US and Europe is hardly helping the situation.
“The United States is now engaged in the process of financial deregulation, in marked contrast to most of the rest of the world. We see signs that the White House, the Treasury Department, and Congress are putting America first, and global regulatory co-operation last.”
A post-Brexit UK will increase the potential for regulatory divergence from Europe, while Russell stressed that Canada’s Co-operative Capital Markets Regulatory System still only involves five provinces and one territory.
He added that the newly-established Financial Services Regulatory Authority in Ontario will develop detailed regulations for the insurance industry and other financial institutions operating in the province.
“It is important that these banking and insurance regulators co-operate with securities regulators to ensure similar rules for similar retail activities.”
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