Feature | Fixed income
“The problem with institutional investors treating such vehicles as readily realisable assets is that it is replicating some of the problems that they have on the less liquid side of their portfolio rather than solving them. In the event of a crisis, ETFs might still be the first assets to be sold but inves- tors might have to accept selling them at a significant discount to their net asset value,” Trow warns. Despite being a fervent advocate of the ETF industry, Mohr acknowledges its shortcom- ings. “The client has to be aware of what they are getting themselves into. Of course,
REGULATORY BLACK HOLES Potential supply and demand problems on secondary markets tie in closely to the role of APs and market makers as providers of market liquidity. For an industry which prides itself for its transparency, very little information is being disclosed about these key actors.
While APs receive their authorisation sta- tus from the asset management firm issu- ing the ETF, which usually discloses a list of all its APs, there has so far not been any publically available centralised information on the total number of authorised partici-
Of course, if they invest in an emerging
market debt ETF, or junk bonds as we would have called them back in the day, treating them as a cash equivalent would not be prudent. Frank Mohr, Commerzbank
if they invest in an emerging market debt ETF, or junk bonds as we would have called them back in the day, treating them as a cash equivalent would not be prudent. “There are limitations to that absorber function,” he adds. “ETFs are by no means a panacea. If the world is really coming to an end and everybody wants to sell, the end investor might not find a buyer. It is only a vehicle to facilitate trading in a more effec- tive manner.” Moreover, despite accounting for only a rel- atively small share of the overall bond mar- ket, research suggests that ETFs are associ- ated with increased co-movement and price volatility of asset prices. Investors hold exposure to an asset by virtue of it being included in an index, rather than analysing its liquidity. “An increase in the co-move- ment of asset prices may pose systemic sta- bility issues, as it makes it more likely that many investors face losses simultaneously, therefore potentially leading to waves of insolvencies and synchronised sales,” the European Systemic Risk Board warns.
pants operating in the ETF market. Regula- tory oversight is further complicated by the fact that due to the decentralised nature of European stock markets, about 70% of European ETFs are traded over the counter, rather than on exchange.
A recent research report commissioned by the Financial Conduct Authority (FCA) sug- gests that the market for APs issuing shares in bond ETFs is concentrated. Indeed, one AP alone accounts for more than half of the markets’ trading volume and the top five cover more than 90% of bond ETF trading volumes. However, the FCA has chosen not to disclose the names of the APs in ques- tion, arguing that the information is confi- dential. For investors in ETFs this should raise the question whether a market can ever be efficiently regulated if the names of key market participants are not even public knowledge.
The European Systemic Risk Board high- lights areas of potential conflicts of interest. For example, APs might be part of the same group which has issued the ETF and they
38 | portfolio institutional | September 2019 | issue 86
could also be the liquidity provider trading ETF shares in the secondary market. This could result in them being reluctant to con- duct arbitrage trades that bring the price in line with underlying securities. For the time being, the issuer side of the ETF market is regulated through Ucits and, to some degree, Mifid or EMIR, yet there is no direct regulation which overlooks APs. Mohr suggests that this might be in part due to the market’s need for flexibility. Indeed, FCA research shows that in previ- ous episodes of market stress, a spike in bond ETF redemptions was swiftly fol- lowed by the emergence of APs, principal trading firms in particular, which absorbed a higher proportion of the redemption volume.
Unlike banks, which have traditionally acted as market makers and APs, principal trading firms tend to have small balance sheets and trade large quantities of securi- ties with zero net exposure by hedging the relevant assets. For Trow, this remains an area of concern. “With banks no longer incentivised to act as market makers, all these people are essentially relying on proprietary traders, the risk of them all wanting to do the same thing is quite high,” Trow says. “Bonds have been on a real tear today, but nobody is going to want to hold opposing positions.
“Proprietary traders have less interest in market developments and more interest in making money at the moment. That suits everybody when we have a strong market but it will not always be like that,” he adds. Liquidity mismatches, conflicts of interest and lack of regulatory oversight; the list of potential pitfalls for ETF investors is long. Could any of these factors become poten- tially fatal for ETF investors? Trow is cau- tious. “It is difficult to say what would knock ETFs over but the fact that in our half an hour conversation we have come up with at least half a dozen of scenarios of how they could be knocked over should be a warning sign. It does not mean that you should not hold ETFs for less liquid securi- ties, but you should treat them as a risk asset,” he warns.
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