ETFs and the ‘liquidity mismatch’ problem

Liquidity ETFs

Concerns around how exchange-traded funds behave during periods of extreme market stress once again came to the fore during the coronavirus turmoil.

Overall, ETFs seemed to pass another test when liquidity vanished from the bond market, in particular, as ETF trading increased and authorised participants (APs) continued to operate in the market.

Both the Bank of International Settlements and the Bank of England stressed the price discovery role ETFs played after liquidity vanished from the underlying market compared to the net asset values (NAVs) which were in catch-up mode.

Although the BoE, in its Financial Stability Report, was happy with the way ETFs traded, it did once again highlight concerns around the potential for a “liquidity mismatch” in some parts of the market, namely emerging markets and the corporate bond space.

“But some ETFs do pose other risks,” the BoE said. “Those ETFs that invest in less liquid assets while offering redemptions in cash can give rise to liquidity mismatch, and result in procyclical investor behaviour.

“And if ETF liquidity became impaired in a stress, this would pose risks to any market participants who were reliant on them for liquidity and price discovery.”

The process has come to be known as an ‘illiquidity doom loop’ where investors run for the exits during spiralling liquidity and exacerbate the sell-off as a result.

Unlike mutual funds however, ETFs have the crucial advantage of a secondary market where investors can buy and sell shares of an ETF without trading the underlying assets.

While there are structural problems in Europe such as the lack of a consolidated tape providing the true liquidity picture for investors, in stressed conditions, the ongoing trading in the secondary market goes some way in protecting ETFs from an ‘illiquidity doom loop’ as the structure is not suffering from the same direct fire sale pressure.

During these conditions, this will result in ETFs trading at discounts investors might not like but at least they can get out if needed. This was seen during the coronavirus turmoil when some 80% of investment-grade bond ETFs traded at all-time high discounts, according to research from Citi.

As one industry source said: “No-one is saying the ETF wrapper is perfect, but it is more perfect than other structures.”

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