EU: EBA's report on good practices for ETF risk management

The European Banking Authority (EBA) today published an opinion addressed to competent authorities (as defined in the Capital Requirements Directive) which outlines a high level description of good practices with respect to the management of key risks that credit institutions encounter through their ETF business units or when dealing with ETFs, to:

• seek to ensure that potential risks associated with ETFs are managed adequately from the perspective of the credit institution – and indirectly from the perspective of its customers; and
• provide guidance as to the evaluation of risk that might emerge at bank level through their operational relationships with ETFs.

Although the opinion is addressed to competent authorities, credit institutions that have business units managing ETFs within their group, and those who may act as counterparties in swaps, securities lending and repos, as market makers/ authorised participants, or as ETF investors, should read it carefully - not least since it contains (in part II) a three-page checklist of questions - under the general headings of  liquidity, counterparty credit risk, and operational risk/conflicts of interest - which they can, in due course, expect their supervisor to be posing to their risk management function (and on which firms need therefore to be able to provide answers/explanations).

ESMA notes that the ESMA Guidelines already strengthen significantly the regulatory framework for UCITS ETFs by putting in place additional disclosure requirements, detailed provisions on collateral management and the rules to be respected when ETFs engage in activities such as securities lending and repo. ESMA therefore expects credit institutions, and their supervisors, as a first step to assess whether the ETF in question is covered by the ESMA Guidelines - if it is, ESMA considers this should provide a level of comfort as to the requirements that apply directly at the level of the ETF (notwithstanding the separate considerations arising at the level of the credit institution).

The good practices cover:

In relation to the ETF business:

• Risk governance/Permanent ETF risk management function
• Introduction of new ETFs
• Defined risk appetite/exposure limits for the ETF business
• Defined market concentration limits
• Documentation of risk policies, methodologies and procedures

In relation to general funding requirements and liquidity:

• Quantifying and monitoring funding needs
• Liquidity risk associated with sudden withdrawals
• Franchise liquidity risk and liquidity metrics

In relation to credit risk and collateral management

• Counterparty credit risk
• Internal reporting
• Collateral management
• Investment of cash collateral

In relation to market risk:

• Ongoing assessment of the tracking error/basis risk
• ETF pipeline risk
• Market making/Authorised participants
• Market discipline

In relation to stress testing framework

• Stress scenarios
• Holistic approach to measuring risk

In relation to conflict of interest policy:

• Conflicts within the group
• Legal documentation