The G20 Financial Stability Board (FSB), the international body tasked with monitoring the stability of the global financial system, has called for regulators to pay increased attention to the exchange traded fund (ETF) market. In a note released today the FSB calls a number of recent ETF market developments “disquieting”.

A “powerful source of contagion and systemic risk” could be created if banks that are most active in derivative-based “synthetic” exchange traded funds run into problems, according to the Financial Stability Board. It said conflicts of interest could arise as a result of the dual role of some investment banks as both providers of synthetic ETFs and counterparties to the derivatives used by the ETFs.

A provider of a synthetic ETF will use investors’ cash to buy a basket of assets to be held as collateral for the swap, rather than buying the constituent stocks of the benchmark index. But the collateral basket could be made up from less liquid equities or unrated corporate bonds from an entirely different market. If investors later decided to withdraw from the synthetic ETF, the provider might face difficulties liquidating the collateral to pay them back. This could force the bank to suspend redemptions from the ETF or it could face a liquidity shortfall if it decided to let investors continue to sell their synthetic ETF holdings.

“In short, risks increases if the bank considers the synthetic ETF structure as a stable and inexpensive source of funding for illiquid securities,” said the FSB. It called for ETF providers and investors to review their ETF risk-management strategies, especially in areas such as counterparty risk and collateral management.

Gregory A. Clay contributed to this article.

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