Exchanging Views on Exchange-Traded Funds
June 10, 2019
Remarks at FSB/IOSCO Joint Workshop on ETFs and Market Liquidity
Welcome to all of you. We are so delighted to be able to host you at the Securities and Exchange Commission for today’s workshop on exchange-traded funds (ETFs). The discussion today is sure to be fascinating. Aside from my greeting, everything I say reflects my own views and not necessarily those of the Commission or my fellow Commissioners.
It is graduation season, so if you have time to walk around the city, you might see graduates of our local schools celebrating in their caps and gowns. The big story of this graduation season was the announcement by a wealthy commencement speaker at one college that he would pay off the debt of the entire graduating class to whom he was speaking. His gift is wonderful, but it may become much more difficult to find commencement speakers, as I suspect that there are few who would be able to match such generosity. The reality is that most graduates will not be the beneficiaries of such kindness from a stranger.
Our capital markets, however, have enabled many parents to save in advance for their children’s education, as well as for their own retirements. ETFs are among the favorite products of American investors. Through ETFs, investors can gain inexpensive and convenient exposure to the markets. As of mid-2017, ETFs were in the portfolios of 7.8 million U.S. households. ETFs are gaining more investor assets every year as more investors come to appreciate that they are a low-cost investment option with tremendous diversity. It is important, therefore, to keep in mind the value of this market innovation to investors even as you think about the important technical aspects of ETFs, the way they operate, and how they affect the broader markets.
The lens of the investor is just one lens through which we should view these markets. The academics and market participants who are with us today will give us a glimpse of ETFs through their lenses. The picture we see will be all the richer because we also can look at it through the different jurisdictional lenses we have in the room. ETFs and ETF marketplaces are not uniform the world over, so we can learn from one another’s experiences. Regulators, academics, and market participants have a long history with ETFs, which should inform our policy discussions.
We ought to approach this topic in the same way that we approach other marketplace phenomena. We need to gather and analyze data before we develop policy conclusions, let alone put those policies into law. As we seek to understand the risks of these products, we need to delve deeply into the institutional details of how ETFs and their markets operate. Without doing so, we will not be able to understand the magnitude of any risks, and whether and how such risks might be transmitted to other parts of the market. A close consideration of market mechanics will also help us to understand the role that ETFs can play in making our financial markets more resilient and efficient. We must undertake our inquiries in a manner that is transparent to market participants, academics, and other interested parties.
These themes of transparency and analytical rigor are ones that Randal Quarles, Chairman of the Financial Stability Board, underscored in a speech he gave earlier this year. In the words of Chairman Quarles: “[A]s we devote more attention to evaluation of new and evolving risks in the financial sector, we must ensure that our assessment of vulnerabilities is based on cutting-edge thinking and a disciplined methodology . . . .” Such assessments, he explained, require the input of a broad range of outside parties—reflective of the broad reach of the policies that might emerge from the assessments. Today’s workshop is an important opportunity for analytical rigor. As we continue the conversation about ETFs, we should make sure to bring in the full range of expert voices on the topic.
The first ETF debuted in the United States in 1993. Without relief from certain aspects of our regulatory framework, these funds could not operate at all. Fund sponsors have to come to us to ask for an exemptive order before they can launch their funds, and we have granted numerous such orders over the past twenty-five plus years. Over this time period, the ETF industry has matured. During the last quarter century, we and market participants have also gathered a lot of information about, for example, how ETF arbitrage mechanisms work, how investors use these products, and the way these products behave during periods of market stress.
After much anticipation, last year, we proposed a rule to standardize the way that ETFs operate. We have received many helpful comments, and I look forward to working on adopting an ETF rule, informed by the comments, later this year. Such a rule will cut the time it takes for an ETF to come to market, which should enhance competition, which, in turn, should benefit investors. A rulemaking is long overdue for a product with which we have so much experience through a range of market events. A prior effort at putting a rule into place petered out in the whirlwind of the financial crisis. The long experience with ETFs that is allowing us to craft a standard framework for these products ought also to inform the continuing international conversation about ETFs.
One aspect of the discussion that deserves consideration is the great variety that characterizes ETFs. Like their traditional mutual fund counterparts, ETFs include index-based funds and actively managed funds. Last month, we approved a non-fully transparent actively managed ETF. Investors also have access to leveraged and inverse ETFs. Leveraged ETFs seek to provide returns that exceed the performance of a market index by a specified multiple over a period of time. Inverse ETFs seek to provide returns that have an inverse relationship to, or that are an inverse multiple of, the performance of a market index over a fixed period of time. These products are not for everyone, and we have taken care to ensure that their disclosures reflect that fact. In addition to diversity of type, there is diversity in how ETFs operate. There is variety, for example, in arbitrage mechanisms, the number and nature of authorized participants, the use of derivatives, and the composition of redemption baskets. ETFs in different jurisdictions may differ from one another on these points, which suggests that we have much to learn from each other.
Given their popularity with investors, ETFs are likely to grow in numbers and assets. A candid and careful analysis of risks associated with ETFs is, therefore, important. Our experience with ETFs suggests that most ETFs are very liquid and their arbitrage mechanisms tend to function well almost all of the time. In the United States, these arbitrage mechanisms have worked so effectively that there have been only a handful of instances in which ETF prices deviated significantly from their fundamental net asset values. There were deviations during the 2010 and 2015 Flash Crashes, but they were short-lived. Authorized participants, driven by the desire to make arbitrage profits, generally manage to keep ETF prices in line with their fundamental values. Economic motivations of this sort can be extremely effective at driving behavior that benefits the markets.
Even informed by the positive history of ETFs, nobody would argue that ETFs will always function without incident. As we try to assess the probability that something will go wrong, we ought also to ask what the likelihood is that if something does go wrong, it will have a meaningful negative effect on the broader financial system. It is important for us to consider the channels through which any ETF problems would roil the financial markets or affect the rest of the economy. For a risk to implicate financial stability concerns, the bar is quite high. During today’s data-filled discussion, I hope that you will encourage one another to be as precise as possible about the exact mechanism by which problems in ETFs could spill over and disrupt the larger financial system or the real economy and how plausible such a scenario is. It is easy to get caught up in the fact that market mechanisms do not work perfectly all of the time, but we need to bear in mind that government interventions to address these imperfections also do not work perfectly all of the time.
Thank you all for your attention. Although I may, in one sense of the phrase, be the commencement speaker for today’s event, I will not be offering to pay off any of your debts. I am, however, indebted to all of you for your participation in this workshop. I am sorry that I will not be able to stay for the discussions, but I know that the Commission staff will benefit greatly from the dialogue. I look forward to hearing the insights they draw from this wonderful opportunity to view ETFs through so many different lenses.
 I am grateful to Penelope Saltzman of the Division of Investment Management and Alexander Schiller of the Division of Economic and Risk Analysis for their assistance in preparing this statement. All views and errors are my own.
 Mike Murphy, Happy Graduation! Billionaire Pays Off Morehouse College Grads’ Student-Loan Debt, MarketWatch (May 19, 2019), https://www.marketwatch.com/story/happy-graduation-billionaire-pays-off-morehouse-college-grads-student-loan-debt-2019-05-19.
 Randal Quarles, Vice Chairman for Supervision, Bd. of Governors of the Fed. Reserve Sys., Remarks at Bank for International Settlements Special Governors Meeting (Feb. 10, 2019), https://www.fsb.org/wp-content/uploads/Quarles-Ideas-of-order-Charting-a-course-for-the-Financial-Stability-Board.pdf.
 See The History of Exchange-Traded Funds, etfguide, https://www.etfguide.com/the-history-of-exchange-traded-funds (last visited June 10, 2019).
 Exchange-Traded Funds, Investment Company Act Release No. 33140 (June 28, 2018), https://www.sec.gov/rules/proposed/2018/33-10515.pdf.