Well-functioning local currency debt markets contribute to a variety of economic and policy goals. Developing local currency-denominated debt markets has become a development policy priority for many emerging market and developing economies (EMDEs).
- Support economic growth by facilitating stable, long-term financing for strategic sectors – including physical infrastructure, housing, and corporate sectors – and by providing relatively safe and liquid savings instruments;
- Build resilience into the financial sector by mitigating the risks associated with external shocks and enabling the development of risk management products;
- Are crucial for the implementation of counter-cyclical fiscal policies to mitigate the impact of financial crises and fiscal cycles. Their importance is compounded in times when banks retrench lending due to liquidity needs or regulatory uncertainty.
Key Constraints for the Development of Fixed-Income ETFs in EMEs
Exchange-Trade Funds (ETFs) – publicly offered investment funds that track an index, a commodity or a basket of assets, and that trade on an exchange – can play a key role in the development of domestic capital markets. Despite their potential to support the development of robust domestic fixed income markets, fixed income ETFs in EMEs amount to less than 1 percent of global ETF assets. The development of fixed income ETFs in EMEs is constrained by a number of factors, including:
Index replication constraints: In EMEs, it is often difficult and costly to purchase the full basket of underlying securities that make up the referenced index. This limits the prospects for growth and liquidity of ETFs, barring the ability of fund managers to attain the level of assets required for an economically viable ETF. Alternative techniques are sometimes allowed, such as (i) holding a sub-set of instruments that are part of the index (portfolio optimization); or (ii) using synthetic structures through derivatives. But these, when allowed by regulation, may elevate tracking error or add counterparty risk in the case of synthetic structures.
Need for broader enabling reforms in domestic capital markets: A full range of enabling conditions need to be in place to support the development of ETFs in EMEs. These include a supporting regulatory and tax framework; sound market infrastructure; and policies to support primary markets and liquidity in secondary markets.
ID ETF: An Innovation that Addresses Key Constraints
The Issuer-Driven ETF is a new financial product, conceived and designed by the World Bank, that aims to bolster the ETF market in EMDEs. The initiative also aims to harness the benefits they provide to add liquidity and transparency in local currency bond markets while advancing public-sector development objectives. The Bank developed the ID ETF concept upon identifying unexploited synergies between ETFs and the role they could play in supporting domestic debt market development.
The key innovation of the ID ETF Program is the direct involvement of a supporting entity – typically a public sector institution working to develop the local currency bond markets. This supporting entity’s role is very much dependent upon the market requirements of the relevant jurisdiction. At a minimum, the structure contemplates that the supporting entity will ensure a pre-agreed amount of underlying securities in the primary market. There may also be other mechanisms for the supporting entity to facilitate secondary market liquidity as needed depending on the degree of development and liquidity in each market. The ID ETF Program structure is flexible to accommodate varying degrees of support from the supporting entity, but a critical component of the product is an initial market needs assessment with each supporting entity such that it can be appropriately tailored for each jurisdiction while addressing the key constraints for a more developed local currency bond market and the economic viability of ETFs.
Indeed, the supporting entity’s role in the ID ETF is unique in the ETF market. The design of the ID ETF addresses the risk that Fund Managers or Authorized Participants (APs) will be unable to secure the underlying securities due to inadequate liquidity. In the value chain of a traditional ETF, APs facilitate the process of creating ETF shares on behalf of end-investors by buying the basket of underlying securities from the market and delivering the same to the ETF sponsors, who will then create the ETF shares for the investors. In the case of an ID ETF, the supporting entity (often the issuer of securities in the referenced index) ensures the availability of underlying securities for the ID ETF and therefore, the problem stemming from inadequate liquidity of underlying securities will be eliminated. Given that under this model of intervention along the value chain of ETF APs are not necessarily needed as intermediaries in the primary market, this innovation streamlines operational procedures and represents process innovation.
The ID ETF provides a number of advantages over a traditional ETF. These advantages include a significant reduction in the cost of tracking the index, streamlining of operational procedures given that fund managers are certain to purchase the entire portfolio of underlying securities in a single operation, and accomplishment of concrete bond market development objectives.
The ID ETF will have several economic benefits. ID ETFs will support ETF industry growth in ways that mitigate risks and generate positive externalities for deeper domestic capital markets and financing for economic growth. Benefits include the following:
- Enhanced economic viability of physically-backed ETFs: Through supporting larger size at ETF launch and enhancing availability of underlying securities, there will be significant cost savings which can ultimately be passed on to investors – an incentive structure built into the product to attract a larger, diversified investor base.
- Minimized systemic risks: Since the ID ETF structure reduces the need for derivatives-based synthetic structures and alternative techniques, systemic risks will be minimized.
- Improved transparency, price dissemination and liquidity in the underlying securities: This is particularly the case for fixed income products that are traded over the counter (OTC) and marked by lower liquidity. Consequently, increased transparency and price dissemination will enhance market access for both retail and institutional investors.
- Greater competition in the financial system: It will promote healthy competition in the financial system by diversifying investment options beyond banks and mutual funds.
- Improved enabling environment for capital markets: In addition to supporting the local debt market development agenda described earlier, it will strengthen the tax and regulatory regimes as well as drive institutional reforms, contributing to further development of the capital markets in EMEs.
- Improved long-term financing for development: Deeper domestic capital markets will provide better conditions for mobilization of greater amount of commercial funds for public investments in strategic sectors, including physical infrastructure and housing. Additionally, it will increase access to long-term finance for large and medium-sized companies and support financial stability
Bringing the ID ETF to Scale: The Role of the World Bank
The ID ETF initiative serves as an example of the work that the World Bank does in assisting client countries in developing deep and resilient capital markets. The ID ETF represents a cross-cutting approach to capital market development across several building blocks of development: providing solutions for long-term financing for strategic sectors, helping create an enabling legal and regulatory framework, providing risk management tools and promoting financial stability. Furthermore, the initiative is important for the World Bank because of the role in supporting domestic bond markets globally as part of the organization’s mandate to promote economic development and alleviate extreme poverty.
The World Bank conceived the ID ETF product and designed the mechanics for the launch and implementation. Moreover, the Bank will add value to the initiative in the following ways:
- Conducting a feasibility study on the viability and appropriateness of the product and assessing context-specific development impact
- Providing technical assistance to assist countries in addressing critical bottlenecks to market development and meet the minimal standards needed for a successful ID ETF product over its life, thereby equipping the client countries with technical knowledge/tools and enhancing credibility
- Increasing the profile of and demand for ID ETF products by consolidating the ID ETF as a global brand
- Supporting the replication to other countries or asset classes as deemed appropriate for the development of financial markets in EMDEs
- Facilitating dialogue across market participants and governments
Implementation: Pilot Project and Opportunities for Scalability and Replicability
The World Bank is conducting a pilot project in Brazil in collaboration with the Ministry of Finance. This is the first phase of a global initiative to leverage ETFs to address critical bottlenecks in the development of local currency fixed income markets in EMDEs. Following the pilot project in Brazil there exist opportunities for scalability and replicability, both of which will result in substantial cost reductions driven by economies of scale and synergies in replication.
Pilot Project – Nature of Collaboration with the Brazilian Ministry of Finance: The World Bank and the Brazilian Ministry of Finance have a strong track record of collaboration on financial sector projects and products. As an advanced EME, Brazil has the key ingredients for piloting this innovative structure: a sophisticated and capable Treasury Debt Management Office, a sound regulatory and market infrastructure, and a mature capital market development strategy, that the ID ETF Program is expected to complement.
Expected Impact in Brazil: The launch of ID Government Bond ETFs is expected to complement ongoing efforts to develop Brazil’s domestic capital market. The initiative intends to help reduce the degree of indexation to overnight rates (SELIC and CDI) by consolidating alternate price references, further diversify the investor base, and stimulate competition in the asset management industry by providing alternate savings mechanisms to retail and wholesale investors.
Global Expansion: The World Bank has the capacity to support this program globally by leveraging its technical expertise and global network to conduct feasibility analyses on the viability of the product for different markets, tailoring the product to the specific context and development needs of each economy.