The growth of exchange-traded funds (ETFs) has raised questions about their effect on market stability. This publication examines the impact of ETFs on the financial system and proposes regulatory actions to mitigate risks.
Exchange-traded funds (ETFs) revolutionized asset markets by using an innovative structure to make investing in a wide variety of asset classes simpler and cheaper. With their growing importance has come increasing concern that these products pose new risks to market stability and performance. This paper examines whether ETFs affect systemic risks in financial markets and, if they do, what the mechanism is by which this impact occurs and what can be done to keep the risks under control. We review current research and empirical evidence on these issues and discuss some emerging risks in ETFs. We ask whether we have the right “rules of the road” to deal with the new drivers of market behavior.
We conclude that ETFs can be a source of systemic risk, in large part because these assets can induce important feedback effects in markets. We also conclude that these effects can be greatly mitigated by careful regulatory oversight and identify various actions one can take to keep the risks under control. Our paper raises the intriguing question of whether we have the right “rules of the road” to deal with the new drivers of market behavior.