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How the US GSIB Surcharge and Basel III Endgame Proposals Would Adversely Impact ETF Markets

  • More and more institutional investors and retail investors rely on ETFs as investment vehicles. The COVID-19 induced market crisis proved ETFs to be a source of market liquidity and stability as investors turned to ETFs to efficiently rebalance portfolios and hedge risk.
  • U.S. GSIBs are key intermediaries in the ETF market, and increasing capital surcharges for ETFs, as proposed, could hurt liquidity in these products and increase costs for investors, including U.S. households.
  • To avoid unduly penalizing U.S. GSIBs’ participation in ETF markets, leading to material adverse impacts on ETF investors, the Federal Reserve should: (1) exclude ETFs from the definition of “financial institution” under the GSIB surcharge proposal, and (2) revise the treatment of ETFs under the Basel III Endgame proposal to ensure capital requirements commensurate with risks.

1. A robust ETF market is a key contributor to financial stability.

Exchange-traded funds (“ETFs”) are pooled investment vehicles that offer access to a broad range of assets, generally with transparency and low cost. Unlike mutual funds, ETFs operate in two markets – the primary market and secondary market – that involve different types of market participants. ETF investors typically trade existing shares intra-day in the secondary market where market makers regularly provide two-sided quotes for ETFs and are key liquidity providers in the ETF ecosystem.

Separately, authorized participants (“APs”) transact with ETF issuers to dynamically manage the creation or redemption of ETF shares in the primary market to keep the price of ETF shares in-line with the value of its underlying securities.1 Many creations and redemptions happen in-kind and do not require securities purchases or sales by ETF issuers. Instead, APs present a basket of securities to (or receive a basket of securities from) the ETF issuer in exchange for ETF shares. In addition, market makers may engage with APs to create and redeem ETFs shares.2 Both APs and market makers – many of them U.S. global systemically important banking organizations (“GSIBs”) – are necessary for robust ETF market liquidity and stability.

According to ETFGI, a leading independent research and consultancy firm covering trends in the global ETFs ecosystem, the U.S. ETF market has grown to $8.12 trillion in total net assets at year-end 2023 (from $992bn in total net assets in 2010) and accounts for 70% of the $11.63 trillion in ETFs net assets worldwide. ETF secondary market trading has consistently averaged about 30% of daily U.S. stock trading in the past decade. And over 12% of U.S. households (i.e., 16.1 million) hold ETFs.3 During the COVID-19 pandemic, despite unprecedented market volatility, the ETF market remained resilient and robust. ETF shares traded efficiently, with market makers continuing to provide liquidity and APs facilitating a significantly higher level of creations and redemptions of ETF shares in March 2020 than in March 2019. The ETF market provided price transparency for investors, particularly in the fixed income market, where market participants faced challenges sourcing liquidity and establishing prices for individual bonds. Retail investors use ETFs as investment vehicles as opposed to single stock names to receive exposure to popular indices like the S&P 500 and sector specific industries, i.e., technology. The ETF market didn’t add additional pressure to financial markets during the crisis. Instead, it proved to be a source of market liquidity and stability as investors, including U.S. households, turned to ETFs to efficiently rebalance portfolios and hedge risk.4

2. Capital requirements for GSIBs’ ETF market activities under the current U.S. capital rules.

Under the current capital rules, U.S. GSIBs are subject to a suite of capital requirements including the minimum risk-based capital requirements, leverage capital requirements, and additional capital buffers requirements (e.g., the stress capital buffer (“SCB”) and the GSIB surcharge). Many of these requirements go above and beyond the Basel international standards as explained previously in our blog, Understanding the Current Regulatory Capital Requirements Applicable to US Banks.

For the risk-based capital requirements, U.S. GSIBs are required to calculate capital using two different approaches – the U.S. Standardized Approach and the Advanced Approaches5 – and use the higher of the two results as the binding risk-based capital requirement. Given the SCB is applied only to the U.S. Standardized Approach, all the 8 U.S. GSIBs are bound by the U.S. Standardized Approach currently. As a result, U.S. GSIBs’ ETFs market activities – whether as APs, market makers or both – are capitalized by the U.S. Standardized Approach and the SCB through the global market shock.

For the GSIB surcharge, exposures arising from U.S. GSIBs’ ETF market activities are included in the GSIB score’s size indicator.6 Also relevant is the interconnectedness indicator. The interconnectedness indicator measures a bank’s systemic importance as it interconnects with other financial institutions since, also captures ETFs. The higher the interconnectedness the more systemically important a bank is. Currently, the Federal Reserve explicitly excludes only bond ETFs from the definition of “financial institution” and is silent with regards to the treatment of other ETFs, e.g., equity ETFs.7 In contrast, the Basel international GSIB score methodology excludes all ETFs from the definition of “financial institution”.8 As we discussed in a separate blog, The Federal Reserve Should Revise the US GSIB Surcharge Methodology to Reflect Real Risks and Support the Economy, relative to the Basel international standards, the U.S. GSIB surcharge methodology generally leads to a more punitive surcharge for U.S. GSIBs even ignoring the divergence in the approach to ETFs.

3. Capital requirements for GSIBs’ ETFs market activities under the proposed U.S. capital rules.

On July 27, 2023 the Federal Reserve released proposals that would materially revise the risk-based capital framework and the U.S. GSIB surcharge framework. In particular, the Basel III Endgame proposal would apply the SCB to the expanded risk-based approach (“ERBA”). The ERBA would also become the binding risk-based capital requirements for U.S. GSIBs. Under the ERBA, the ETF market activities would be capitalized by the Fundamental Review of the Trading Book (“FRTB”) framework and the operational risk framework (for fee income associated with market making activities) in addition to the SCB. In particular, the proposed FRTB framework provides a suite of approaches for capitalizing ETFs9 depending on whether it is feasible to look-through the funds to all individual underlying constituents. Funds that cannot be looked through would need to be capitalized using one of the three approaches with increasingly more conservative outcomes chosen based on the selection criteria set out in the proposal. The SIFMA’s quantitative impacts study shows that the FRTB framework alone would more than double the capital requirements for U.S. GSIBs’ trading and market making activities.10

Separately, contrary to the Basel international standards, the GSIB surcharge proposal would expand the definition of “financial institution” to include all ETFs leading to an even higher surcharge for U.S. GSIBs, potentially discouraging U.S. GSIBs from intermediating the ETF market. Consider, for example, an ETF tracking a broad-based equity index such as the S&P 500. Many of the index constituents are not financial institutions, and thus do not count toward the interconnectedness indicator. Whereas the ETF, as an equity ETF, is included in the interconnectedness indicator. As a result, equity ETFs are scored more punitively than the constituent securities that compose the ETFs’ holdings. Similarly, certain equity ETFs are capitalized more punitively under the GSIB surcharge rule than other securities that provide comparable economic exposures, e.g., index futures. It was observed that in some cases the punitive U.S. GSIB surcharge has impacted U.S. GSIBs’ capacity to “provide liquidity to ETFs, and ability to recognize the benefits of using ETFs as hedging vehicles to reduce risk”.11 This would negatively impact U.S. market liquidity and price discovery while increasing costs for investors, which include pension funds, 529 colleges savings plans, and retirement savings through IRA and 401K accounts.

4. The Federal Reserve should revise the treatment of ETFs under the GSIB surcharge proposal and the proposed Basel III Endgame.

The two-markets structure of ETFs and the in-kind primary trades help to reduce the interconnectedness concerns expressed by the Agencies and is acknowledged in the GSIB proposal. Therefore, ETFs should be excluded from the definition of “financial institution”.

Additionally, the capital treatment for ETFs9 remains in general excessively conservative under the proposed FRTB framework and the SCB leading to outsized capital requirements. The Federal Reserve should carefully deliberate and revise the treatment of ETFs under the FRTB framework to ensure capital requirements are commensurate with risks. To facilitate the deliberation, SIFMA put forward several recommendations that the Federal Reserve could consider including creating additional buckets for funds (see Table A1 of the Appendix) and an alternative approach that maps a fund’s risk sensitivities to relevant buckets for non-funds.12

5. Conclusion

For the reasons laid out above, ETFs should be excluded from the definition of “financial institution” for purpose of the U.S. GSIB surcharge proposal. Additionally, the treatment of ETFs should be revised under the FRTB framework of the Basel III Endgame proposal to ensure capital requirements for banks’ ETF market activities are commensurate with risks. These amendments would help ensure capital requirements for U.S. GSIBs’ ETFs market activities are commensurate with the risks that they create, would align with the Basel international standards for GSIB surcharge, and would help ensure the liquidity and efficiency of the ETF market. Additionally, these amendments would ensure investors, including U.S. households, continue having access to the ETF market at reasonable costs and would not see an increase in transaction costs in ETFs.

Authors

Dr. Guowei Zhang is Managing Director and Head of Capital Policy.

Ellen Greene is Managing Director, Equity and Options Market Structure.

Lindsey Keljo is the Head of SIFMA’s Asset Management Group.

Appendix

Table A1. SIFMA Proposed investment fund buckets by asset class, fund type, and credit quality.

Table: SIFMA Proposed investment fund buckets by asset class, fund type, and credit quality.

Footnotes

  1. APs have no legal obligation to create or redeem ETFs shares. They are compensated through their market making activities in the secondary market, or through service fees they collect from clients who may engage them to facilitate primary trades. Additionally, APs could initiate a creation (or redemption) if the price of an ETF share is greater than (or falls below) the value of the underlying holdings to take advantage of arbitrage opportunities in the market. [↩]
  2. Some market makers are also APs. [↩]
  3. See https://www.ici.org/system/files/2023-05/2023-factbook.pdf [↩]
  4. See https://www.blackrock.com/corporate/literature/whitepaper/viewpoint-lessons-from-covid-19-etfs-as-a-source-of-stability-july-2020.pdf [↩]
  5. Under the current capital rules, banks may use internal models to calculate capital requirements for credit risk, market risk, CVA risk and operational risk. These internal models collectively referred to as the Advanced Approaches. [↩]
  6. In the U.S., the applicable surcharge is calculated as the higher surcharge of two methods – “Method 1” is the standard adopted by the Basel Committee on Banking Supervision for identifying and setting the surcharge for GSIBs and depends on five sets of systemic indicators – size, interconnectedness, complexity, cross-jurisdictional activity, and substitutability. “Method 2” is a U.S. only creation that generally employs the Basel methodology but replaces the substitutability indicator with a short-term wholesale funding (“STWF”) indicator. The GSIB score is the weighted sum of all 5 indicators. The higher the score the greater the systemic importance, and thus the higher the GSIB surcharge. [↩]
  7. See https://www.federalreserve.gov/apps/reportingforms/Download/DownloadAttachment?guid=ba9b1d68-3a2a-4472-84e6-0130d5c8a601 [↩]
  8. “For the purpose of the interconnectedness indicators, financial institutions are defined as including banks (and other deposit-taking institutions), bank holding companies, securities dealers (including institutions that are strictly securities brokers), insurance companies, mutual funds, hedge funds, pension funds, investment banks, central counterparties (CCPs), asset management companies and private equity funds.” See https://www.bis.org/bcbs/gsib/instr_end23_gsib.pdf [↩]
  9. And other equity positions in an investment fund. [↩] [↩]
  10. See https://www.sifma.org/resources/news/sifma-responds-to-u-s-basel-iii-and-g-sib-surcharge-consultations/ [↩]
  11. See https://www.blackrock.com/corporate/literature/publication/blk-comment-basel-iii-endgame-gsib-surcharge-proposal.pdf [↩]
  12. See https://www.sifma.org/resources/submissions/regulatory-capital-rule-amendments-applicable-to-large-banking-organizations-and-to-banking-organizations-with-significant-trading-activity-sifma-and-isda/ [↩]

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