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ETFs Are Becoming a Shadow Banking System, Tullett’s Smith Says

Exchange-traded funds are developing in a similar way to the shadow banking system that almost brought down the world’s financial system in 2008, according to Terry Smith, chief executive officer of Tullett Prebon Plc.

ETFs often fail to track the underlying asset whose behavior they’re designed follow, are exposed to the risk of a provider going bankrupt and are vulnerable to heavy short-selling, Smith, 58, wrote today in a blog titled “ETFs - Worse than I thought.”

Smith, a former analyst at UBS Phillips & Drew, founded London-based money-management firm Fundsmith LLP last year and is aiming to raise funds from retail investors seeking low-cost equity funds. Tullett Prebon is a London-based inter-dealer broker with a market value of almost 800 million pounds ($1.3 billion). Smith was dismissed from his job at UBS in 1992 after publishing a book called “Accounting for Growth,” which showed how companies manipulated profit figures.

“We may soon have to worry about the direct retail involvement in ETFs,” Smith wrote. “There are echoes of the parallel banking system in the credit crisis here.”

ETFs are typically designed to mimic the performance of gauges such as the Standard & Poor’s 500 Index. Unlike mutual funds, whose shares are priced once daily after each trading session, ETFs are listed on an exchange where shares are bought and sold throughout the day. Global ETF assets grew to $1.37 trillion as of February from $74.3 billion in 2000, according to BlackRock Inc., the world’s biggest money manager.

‘Obvious Dangers’

Without owning the underlying assets, ETFs can move in the opposite way to which investors expect, Smith said. As they consist of various swaps, they are also exposed to the risk of a counterparty failing, he said.

“There are obvious dangers in such an arrangement in the areas of counterparty risk and collateralization of the sort which caused so many problems during the credit crisis,” Smith wrote.

The speed of recent development in the ETF market and its growing complexity calls for “closer scrutiny,” the Financial Stability Board, a panel of global regulators in Basel, Switzerland charged with rewriting the rules for international finance, said last month.

“The drivers and implications of the recent wave of financial innovation in ETF markets warrants closer surveillance of potential vulnerabilities by financial stability authorities to ensure that the market grows in a sustainable and safe way,” the FSB said.

ETFs are also vulnerable to unlimited short-selling because of the ease of creating new shares, according to Smith, who said short-selling in some funds has reached 1,000 percent. “The scope for a short squeeze is tremendous,” he said.

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