The close information links between ETFs and equities creates the potential for “illiquidity contagion” in equities but not the fixed income market when there is an ETF demand shock, according to a white paper by the Central Bank of Ireland (CBI).

The CBI research, entitled Information and liquidity linkages in ETFs and underlying markets, found equities are more closely linked to ETFs than bonds as they are also exchange-traded and therefore are easier for market makers to arbitrage due to lower transaction costs.

As a result of this closer link, the white paper said ETFs have the potential to spread liquidity shocks to their underlying equity holdings but not underlying bonds as they are traded over-the-counter (OTC) and not on exchange.

The lack of accessibility of the OTC corporate bond market is the key driver of the weaker information links formed with ETFs. This, the report added, has also been amplified by banking regulations following the Global Financial Crisis (GFC) which have caused a deterioration of corporate debt market liquidity due to the contraction of market-making activities.

Paweł Fiedor, senior economist at the CBI, and Petros Katsoulis, PhD candidate at Cass Business School, and co-authors of the report, said: “ETFs can propagate liquidity shocks to the underlying equities but not to the corporate debt securities, because when ETFs lose their informativeness when they become more illiquid, the information link with equities breaks down, propagating the liquidity shock to them.

“As a result, we document illiquidity contagion occurring between ETFs and equities but not between ETFs and debt securities since a breakdown of the information link when ETFs become illiquid would affect equities more severely than debt securities.”

Furthermore, the white paper, which studied the Irish ETF market specifically, found increasing ETF ownership and ETF flows could have a “substantial” effect on the volatility of the underlying equities while in the bond market, ETF ownership increases led to a reduction of volatility.

“This suggests that as ETFs invest more in the equities, they facilitate arbitrage activity which strengthens the information link and increases activity in the equities, leading to higher volatility.

“In contrast, higher ETF ownership of corporate debt securities encourages investors to migrate to ETFs because of their higher accessibility, weakening the information link and decreasing the volatility of the corporate debt securities.”

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The findings go directly against recent academic research which found rising corporate bond ownership in the ETF space was impacting the liquidity of the bond market.

The study, conducted by Efe Cotelioglu, PhD candidate at the Swiss Finance Institute, argued higher ETF ownership was reducing the ability of investors to “diversify liquidity risk”.

However, CBI’s Fiedor and Cass Business School’s Katsoulis said: “Our results indicate that ETFs can affect the underlying markets in different ways depending on their accessibility

“Equities’ volatility increases due to increased arbitrage activity as ETF ownership increases, but debt securities’ volatility decreases as investors satisfy their liquidity demand through the (more liquid) ETFs.”

Image source: By William Murphy from Dublin, Ireland - THE CENTRAL BANK OF IRELAND [NEW HEADQUARTER BUILDING ON NORTH WALL QUAY]- ALONG BOTANIC AVENUE [JANUARY 2018]-135336, CC BY-SA 2.0