Trading bond ETFs may quickly become much cheaper thanks to new regulations, claims one of the largest ETF market makers.
Last year, the SEC introduced a new set of rules aimed at levelling the playing field in the ETF industry. These rules – collectively known as the “ETF rule” – aimed to bring more standardisation to ETF regulation. Historically, American ETF regulation has been fragmented and bespoke, with different companies getting different treatment.
Importantly, the ETF rule gives everyone more flexibility in deciding what securities can go in and out ETFs when they are created and destroyed, in a process called “creation redemption” in industry jargon.
This flexibility has proved especially useful for bond ETFs, as it is often difficult and expensive for traders to buy, sell and hold certain bonds. These higher costs can then be passed on to investors in the form of worse prices, or “wider spreads”. As such, both traders and investors can benefit from flexibility around which bonds go in and out of ETFs.
But prior to the ETF rule, this flexibility was more available to some ETF providers than others.
Speaking at the BNY Mellon and ETF Stream webinar, Brian Gilman, head of ETF sales at Virtu, one of the most influential ETF trading businesses, said the new ETF rule promised to make trading bond ETFs cheaper for everyone. He said:
“One of the big advantages that fixed income [ETFs] have is their fungibility. So market makers can lay risk off one product off onto another through this fungible creation redemption process. By taking all fixed income products on this level playing field you’re going to grow this fungibility. So you’re going to see this added liquidity to the fixed income space and with that lower spreads.”
He added the ETF rule will also help cheapen bond ETF trading by reducing the number of bonds and ETFs that traders must hold when bond ETFs get created and destroyed. A common complaint from traders has been that creating bond ETFs requires holding too many bonds and ETFs. The high number of bonds and ETFs required can be measured by the “creation unit size”.
“Issuers can now determine their creation unit size with a lot more flexibility than in the past,” Mr Gilman said.
“And with that market makers will be able to control their inventory costs much more easily. With reduced inventory costs you’re going to see tighter spreads on screen.
“A big part of the on screen spread that you’re going to see for retail trading is paying for the costs of a market maker to hold inventory. So with smaller creation unit sizes and less inventory costs, you’ll see tighter spreads.”
