Bank of England: ETF trading in secondary market lowers risk of fire sale

Tom Eckett

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Investors found it easier to trade ETFs compared to their underlying assets during the recent market stress, according to the Bank of England (BoE).

According to the BoE’s Interim Financial Stability Report released earlier this month, daily trading volumes in ETFs rose as much as three times in March for some corporate bond ETFs versus their January averages.

Furthermore, the BoE found ETF prices provided information about future changes in the underlying assets highlighting ETFs incorporate information quicker than net asset values (NAVs).

When ETFs were trading at all-time high discounts amid the coronavirus turmoil, the report said this showed how NAVs were not factoring in the latest price information meaning real-time prices were more accurately reflected in the bond ETFs.

Last month, the Bank for International Settlements (BIS) also found the recent discounts showed how ETFs offered accurate pricing “in a more timely manner”.

“In light of the relative liquidity in ETF shares compared to the corporate bond market, price discovery was often occurring via ETFs rather than their underlying assets.

“Lower ETF prices – which more accurately reflected the liquidity and the cost of selling the underlying assets – could have been an indication of the extent of first-mover advantage that was available to investors in open-ended funds holding similar asset portfolios to those ETFs, as investors redeeming from open-ended funds early might receive the potentially higher NAV price.”

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Along with the price discovery benefit, the BoE highlighted the structural benefits of ETFs to have the ability to trade in the secondary market including the immediate liquidity at intra-day prices and the lower risk of a dynamic that leads to the fire sales of underlying assets.

“The secondary market trading of ETFs means there is lower risk of a dynamic that incentivises the fire sales of their underlying assets.”

The BoE did warn ETFs offering exposure to less liquid assets could lead to a liquidity mismatch if many investors head to the exits at once.

“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.”

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