Large institutions, pension funds, and individual investors routinely cycle trillions of dollars through insurance products and mutual and exchange-traded funds. These three investment platforms until recently have not been closely scrutinized by financial regulators, as they were deemed to pose little if any systemic risk. This was in contrast to the more exotic financial vehicles, in particular derivative instruments such as mortgage-backed securities and credit default swaps that were at the heart of the Great Recession.
With the passage of time, however, a greater focus on liquidity considerations, developing technology, and changes that have evolved in the fund industry are reframing the regulatory landscape. One factor at work has been the dramatic growth in the size of ETFs that has taken place and is expected to continue. The expansion of ETF investments stems partly from the fact that they tend to have a lower fee structure than mutual funds.
More important, however, is the fact that since ETF ownership is through shares that are traded on exchanges, investors can reduce or expand positions on an intraday basis, as well as short or buy futures in the funds. ETFs thus appeal to a broader base of investors in contrast to mutual funds and insurance products, which have mainly been held by pension funds and individual investors anticipating retirement.
ETFs have grown both in the varying range of assets that are held and especially in the relative size of holdings. Inflows to ETFs worldwide reached $464 billion in 2017, up from $288 billion in the preceding year, while the total global ETF asset base hit $4.659 trillion in 2017 from $3.396 trillion at the end of 2016. Mutual fund inflows in 2017, by contrast, were only $91 billion. In the U.S., ETF assets at the end of 2016 were only about $2.5 trillion, compared to total mutual fund assets of $16.3 trillion.
The dramatic growth in the relative distribution of fund holdings, the perceived change in risk posture implied by fund assets being traded daily in markets, and the added factor of cybercrime have occasioned a shift in financial regulators’ perspective. They would like to know, for example, what might happen if the insurance industry became the target of widespread cybercrime and whether a targeted institution could pull others down with it.
Government officials have raised the possibility that managers of a mutual fund could find themselves with too many illiquid assets during a run on redemptions, raising the specter of a domino effect. Regulatory analysts want to make sure that they, and investors, can differentiate ETFs from their other fund cousins enough to be comfortable that ETFs do not have some potentially destabilizing characteristic. Finally, the international regulatory arena will shape policy governing these financial products because the U.S. coordinates with other major world economies. The interconnected and global nature of finance has caused international coordination to become today’s reality.