ETFs can trigger next crisis: expert

America’s next financial crisis will likely come from the growing complexity of financial products such as exchange-traded funds (ETFs) and derivatives, both of which comprise a large portion of the market.

That’s the belief of Thomas Caldwell, chairman of Caldwell Securities Ltd., a Toronto-based firm. “Today’s flavour du jour usually becomes tomorrow’s crisis,” he said, speaking recently in Toronto at an event organized by The Empire Club of Canada.

“ETFs have been very heavily promoted by the media and the banks because [banks] make money trading the underlyings,” Caldwell said in a post-event interview. As a result, he added, ETFs now make up such a large portion of the market that they have the ability to affect share prices.

“A company stock might move now on a weighting change in an index versus a corporate fundamental,” he said. “ETFs are distorting market pricing. And if [something] distorts market pricing, it introduces the possibility of collapse.”

Another problem with ETFs is their complex structure, which can bring many risks that are not always immediately known, Caldwell explained. “You can have some of these double and triple [ETFs]—and if something cataclysmic happens in the market, there’s a very good possibility that some of the people exposed to the underlyings could get themselves into trouble.”

For similar reasons, the world of derivatives also poses a threat that could translate into a future financial crisis, Caldwell added. Major U.S. banks have an exposure to derivative products that is worth trillions of dollars, and there is still little clarity about exactly what these products are, he explained.

“We can delude ourselves, ‘Gosh, we’re really smart; [these are] wonderful products,’” Caldwell said of both derivatives and ETFs. “I think we’re there now. We just haven’t heard the bang yet,” he added, drawing a parallel with the 2008 financial crisis, which was precipitated by complex instruments bearing top credit ratings but full of junk mortgages.