Are ETFs Making Some Asset Managers Too Interconnected to Fail?

Abstract

Exchange Traded Funds (ETF) are likely the most successful financial products since the 2008 global financial crisis (GFC). Despite numerous benefits, ETF’s success could be making some asset managers “too interconnected to fail.” Interconnection is a core element of systemic risk, and it played a material role in the transmission of economic shocks in the GFC. This article is the first, in a growing body of literature on ETFs, to provide a comprehensive inquiry into their systemic importance through the lens of interconnectivity. The article provides three unique contributions. First, it shows how ETFs are creating deep and complex interconnections between numerous market participants and service providers, extending to retail and institutional investors, and corporate behaviors and decisions. Second, it illustrates how ETF interconnection creates direct and indirect systemic risk transmission pathways, with unique factors not present in other managed asset products, like the reliance on key market-incentivized intermediaries in a crisis, crowd behaviors from correlated investment exposures, information cascades, runs, fire sales, and non-linear impacts. Finally, it shows how the effective monitoring of ETF systemic risk requires a cross-market analysis to assess the collective behaviors of numerous participants in a complex and interconnected operating ecosystem, and how both activity and entity-level oversight is prudent in this market. While ETF firms are distinct from banks and insurance companies, there’s merit in safeguarding large firm’s economic resilience given their centrality in a highly interconnected ecosystem. As such, ETFs illustrate the importance of considering financial markets as a “system” when designing supervisory frameworks.

Keywords: Exchange Traded Funds, ETF, Systemic Risk, Too Connected To Fail, Too Big To Fail, Financial Crisis, Arbitrage, Authorized Participant, Contagion, Herding, Fire Sales, Information Cascades, FSOC, Activities-based, entity-based

JEL Classification: K22, K29, G01, G23