Of dogs and tails and ETFs

by , 25th February 2019

The ongoing debate about what comes first – market instability or a flushing out of ETF monies – shows no sign of abating.

The latest to stir the pot of Jason Xavier, the head of EMEA ETF capital markets at Franklin Templeton Investments, who this week has attempted to answer the question by looking at what would happen if either a market maker or an authorised participant were to face an insurmountable liquidity hurdle. Or go bust in the parlance.

Xavier starts by looking into the question of whether ETFs exacerbate volatility. As he says, volatility is a function of investor flows. “Ultimately the decision to direct an investment resides with the end-investor. The vehicle used to express this decision can vary: from participating in mutual funds or ETFs to buying/selling the underlying stocks or bonds directly. And investors will experience different levels of transparency, depending on their choice of vehicle.”

In this sense, ETFs are a good thing because of their democratising aspect i.e. any investor using them has fully executable transparency throughout the trading day, allowing them to see how risk is changing throughout the day.

What happens next?

But what happens should a market participant fail? The ETF ecosystem features a number of Authorised Participants or APs meaning that ETF managers are not reliant on one intermediary.

Authorised participants (AP) act as an intermediary between buyers and sellers of ETF shares. An AP has authority to trade in the primary market, facilitating creation and redemptions directly with the ETF issuer/asset manager.

Xavier points out that APs are financial institutions, typically household banking and stockbroking organisations already fulfilling both primary and secondary market trading in all listed securities for mutual funds, ETFs and ultimately single stock/bond activity.

“So if we’re considering the implications for the ETF market of an authorised participant failing or withdrawing, we should also look at the other roles these organisations fulfil in the wider investment universe,” he says.

With all such companies they are participating in the market because there is an economic benefit to incentivise involvement.

“There is no more obligation for an authorised participant to act as an intermediary in the trading of mutual funds or individual stocks than there is for ETFs,” says Xavier. “Execution commission and arbitrage opportunities are often considered benefits for facilitating primary and secondary market transactions. Indeed, both execution commissions and arbitrage opportunities provide incentives for primary market ETF trades.”

“Therefore, if one—or even more than one—participant should step away, others should remain to provide a solution ensuring market liquidity.”

But, asks Xavier, what if there were to be a more systemic issue that meant there were no market participants to facilitate primary market trading in ETFs?

“Given that most of these players also underpin the wider trading in stocks and bonds globally, their reluctance or inability to trade would likely have wider implications, not just for the 5% of the market made up by ETFs, but for the other 95% too,” he points out.

As Xavier concludes, in a comment that is worth highlighting considering how much this subject has been given an airing over the years, “that’s scarcely a case of the tail wagging the dog.”

We doubt this will bring an end to the debate – indeed, we suspect that even a cataclysmic crash of the likes not seen for, oh, about a decade, will end the arguments. But for now this type of reasoned argument at least sets us up for the next round of blame-sharing.

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