New Funds, Familiar Fears : Are Exchange Traded Funds Making Markets Less Stable? Part II – Interaction Risks

Exchange Traded Funds (ETFs) – tradeable investments that provide a return linked to an underlying index or basket of assets – are likely the most successful financial product since the 2008 crisis. Over the last decade they've experienced remarkable growth. Yet these products may also be making the financial system less stable and, like Wall Street innovations of the past, connecting banks and main street with dangerous implications. This final article – of a two-part study on ETF risks – posits that these products may be introducing two “interaction risks” into financial markets due to a complex operating and trading ecosystem. First, ETFs could create information cascades, facilitate investor herding, and financial contagion. Second, ETFs could be distorting the informational efficiency of underlying asset and securities prices, and disincentivizing active price discovery, in a way that masks market risk.This article builds on its predecessor, which showed how ETFs could create a fragile “illusion” of liquidity, since financial intermediaries, in a crisis, often act unpredictably and pursue discretionary incentives. The combined study compliments prior work on financial market systemic risk by analogizing ETF interaction risks to prior crises – particularly 2008. Given the comparisons, the ETF market's continuing growth and interest by retail investors, institutions, and pensions, regulatory and academic attention should be increased to ensure risks are both understood and appropriately mitigated. This article introduces several areas where heightened focus is warranted