One of the biggest market makers Jane Street Group has responded to repeated claims ETFs are a systemic threat to financial markets during periods of rapidly vanishing liquidity.
The Jane Street report, entitled Credit ETF Trading in Stressed Markets, said the concerns highlighted by regulators and onlookers were unfounded and ETFs would continue to trade even if liquidity does become strained.
The vehicle has come under fire in recent times. Last year, the European Central Bank (ECB) warned ETFs have the potential to amplify risks in the financial system, in particular, highlighting the counterparty risk in synthetic ETFs and liquidity risks in the primary and secondary market.
Furthermore, in June, the European Systematic Risk Board (ESRB) argued the role of the authorised participant was of concern.
Marco Pagano, chair of the ESRB’s Advisory Scientific Committee, added: “APs engage in the creation and redemption of ETF shares in pursuit of profit and have no commitment to ETF sponsors or investors. Therefore, in stressed conditions, APs could simply decide not to engage in ETF redemptions.”
However, Andrew Upward, ETF strategist at Jane Street, and author of the report, explained, market makers are, in fact, incentivised to remain in the market as prices fall so they can profit when they snap back.
Even in a truly distressed market where bonds simply cannot be sold, he added market makers may still own bond ETFs at prices that “are low enough to compensate them for them for taking more risk” while they wait for flows to become two-sided again.
Furthermore, another factor which helps ETFs resiliency is the competitive environment market makers are in.
This, he said, encourages market makers to trade and manage risk as efficiently as possible meaning they can do more than simply arbitraging investor trades.
In fact, market makers can simply hold ETFs on their balance sheet if they believe selling pressure will only last a short time or they can use other ETFs to hedge if they think selling is only limited to certain areas of the market.
Creation, redemption and authorised participants
Upward commented: “Market makers lay off risk by selling bonds or derivatives where practicable, and they take risk opportunistically or with the goal of selling the bonds (or the ETFs) over a longer time horizon.
“Selling the bonds more patiently tends to reduce a market maker’s trading costs, and it also diffuses the impact of net ETF selling on the underlying bond markets.”
Even in times of stress, the report said the structures, processes and incentives underpinning the ETF market will transmit investor selling pressure to the underlying credit markets.
Upward concluded: “ETF liquidity may become strained and expensive in accordance with any strain in the underlying markets, and that may not be intuitively obvious to some investors.
“But ETFs will continue to trade, will continue to generate valuable information about where the underlying bonds are trading, and will continue to offer investors who are looking to exit their positions a means by which to do so.”
