Back in the 1990’s, when I was a market maker on the floor of the Chicago Board of Options Exchange (CBOE), options trading was different; options were quoted in fractions, there were only monthly expirations, and all trades were conducted in person.
This last item is particularly important. Because of the rules of being a market maker or specialist, when you quoted a price, which consists of both a bid and ask, you were required or held to buying or selling at least 10 contracts at those prices. This was known as “the 10 Up Rule,” and it guaranteed at least some minimum of liquidity.
Without this rule, especially during volatile periods, orders might find themselves entering a vacuum. This could lead to huge slippages in price, without any actual trades happening. This is essentially what happened during flash crash. And with the advent of electronic trading, human market makers fell by the wayside, so this dynamic occurs to a lesser extent every day now.
Basically, computerized ‘specialist’ systems are not bound to honor the quotes you see on your screen. They can be yanked, or disappear in a fraction of a second before your order, which was entered at the bid or ask, can be executed.
Couple this with the rise of ETFs, in which large baskets of stocks and options need to be executed simultaneously and it can lead to a gaping hole of liquidity just when it’s need most during times of volatility.
The Wall Street Journal has an important piece on the vulnerability of ETFs to liquidity jams, especially the funds tied to high-yield bonds.
Bets against exchange-traded funds have hit multiyear highs as some investors question whether this industry—which grew rapidly in the bull market—could handle sudden redemptions in a downturn.
Investors are shorting the shares of some ETFs that buy securities like high-yield debt, which may be hard to sell if markets turned suddenly, a fear stoked by increased volatility this year.
The ETF industry is now worth more than $4 trillion, up from below $1 trillion in 2008, raising its importance in the global financial system and magnifying the risk if the funds run into difficulties.
Still, other analysts point to relatively recent episodes, like the rise in spreads on high-yield bonds in 2015 and 2016, as proof that ETFs can manage periods of stress well.
“It’s going to get pretty interesting here with the Fed proceeding with interest rate hikes. You have a 30-year bull market in fixed income and people aren’t used to what happens if there’s a downturn in that market,” said Daniel Gallagher, a former commissioner of the Securities and Exchange Commission and currently chief legal officer at pharmaceutical company Mylan.
ETF shares are created by so-called authorized participants—broker dealers who buy the securities that make up an index tracked by a fund and exchange them for new ETF shares.
When investors want to redeem their shares, the process works in reverse and the ETF must sell the securities. If market liquidity tumbles, some investors worry that the funds won’t find buyers for those bonds.
“Liquidity can be the next trigger of a crisis. Trust in the instruments of the market can be questioned, especially with so much leverage,” said Vincent Mortier, deputy chief investment officer at Amundi, Europe’s biggest asset manager.
Others argue that corporate-bond ETFs already have fared well in volatile markets. Shelly Antoniewicz, senior economist at the Investment Company Institute, points to stresses in the high-yield market in late 2015 driven by tumbling commodity prices as an example of their resilience.
Different measures of the depth of the credit market offer a mixed picture. Average daily trading volumes have only risen in recent years, ticking above $30 billion in 2017, nearly double their levels before the financial crisis.
But dealer inventories of corporate bonds have fallen precipitously, from as high as $250 billion ahead of the financial crisis to less than $30 billion today.
The prospect of a liquidity mismatch between an ETF and its underlying investments has also raised questions about the credit lines often extended by a syndicate of lenders to some ETF sponsors.
If the assets held by an ETF are seen as too illiquid to sell, managers could instead tap the credit lines available to cover redemptions, in the hope that volatility subsides and underlying assets can be sold at more reasonable, reliable prices later on.
But that logic depends on the volatility subsiding, and prices rising—otherwise, existing investors are left footing the bill for the tapped credit line.
“When you have a liquidity event it’s like squeezing an elephant through a keyhole,” said Mike Thompson, president of S&P Investment Advisory Service.
There can be a snowball effect, and we refuse to do it. It’s becoming a very big issue,” he added. “It’s a strange way to treat existing investors because you then need to reimburse the loan.”
In 2017, a report by the Financial Stability Board noted that while credit facilities could reduce financial stability risks, they could also act to raise leverage on already distressed funds and increase the threat of contagion to the wider financial system.
“[A credit line] clearly helps smooth out illiquid markets. My concerns would be if it was prolonged and significant. No one can read the markets so it’s a bet on liquidity and more stable markets returning—which may or may not happen,” said Hector McNeil, co-CEO of ETF provider HANetf. “My other issue is that the risk is ultimately shouldered by the legacy holders of the ETF—the ones who have redeemed are safe.”
A recent consultation by the International Organization of Securities Commissions yielded few worries about liquidity risk in the ETF industry. Some respondents suggested that secondary market trading in ETFs made them less susceptible to liquidity risks.
