The rapid growth of the ETF industry means regulators have their work cut out trying to keep up with the changing nature of the ecosystem.
One area of ongoing focus for regulators is the role of authorised participants (APs) with regards to ETF liquidity, especially during periods of market stress.
APs play a vital role in maintaining tight bid-ask spreads and ensuring ETFs trade as efficiently as possible. Without the AP arbitrage mechanism, ETFs effectively trade like close-ended funds.
IOSCO, the Central Bank of Ireland and the Financial Stability Board have all expressed concerns at some point over the years about what happens to ETFs if APs step away.
The often-highlighted example came in 2013 when Citigroup temporarily stopped accepting orders to redeem causing ETF discounts to widen significantly to their net asset values (NAVs).
The key reason for these concerns is APs are free to act within their own commercial interests and have no obligations to take part in the creation-redemption process.
As Tara O’Reilly, co-head of asset management and investment funds group at Arthur Cox, said on ETF Stream’s webinar last week: “There is a focus [from regulators] on how important APs are to the resilience of the liquidity of an ETF.
“Despite the critical nature of [their role], the AP has no fiduciary duty to the ETF and no legal obligation to create or redeem shares.”
This means, in a period of extreme market stress, investors could find themselves unable to exit a trade at a reasonable price as bid-ask spreads widen to levels far higher than the underlying market.
However, the ecosystem saw the complete opposite occur during the coronavirus turmoil as APs continued to stay in the market.
According to research conducted by Invesco, the same 16 APs were active across its ETF range for both February and March during entirely different market environments.
Furthermore, the firm’s top three APs lost market share during the more volatile March highlighting how uncertain markets is viewed as an opportunity to increase trades by these liquidity providers.
Despite this positive development, regulators are not fully satisfied. One concern for regulators is many APs, such as banks, can also trade their own inventory for profits.
According to Yao Zeng, assistant professor of finance at the University of Washington, and bond ETF trading expert, this can lead to a conflict of interest.
He told ETF Stream: "When the banks’ balance sheets are constrained, they can withdraw from ETF arbitrage. But worse, because ETFs are easier to trade than bonds, APs may even create ETFs for the purpose of managing their illiquid corporate bond inventory rather than for closing the price gaps between the ETF and bond markets, thus further distorting ETF arbitrage and leading to even larger price gaps."
In response, O’Reilly has suggested a set of best practice guidelines could be implemented in order to ensure a conflict of interest does not arise and APs continue to provide liquidity to the ETF market.
Plenty of food for thought for regulators which continue to monitor developments closely.
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