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The Investment Association finds ETFs provided liquidity during market crisis


The UK’s Investment Association finds that in the view of their members: “ETFs have proven themselves resilient despite the initial market shock and that they have provided a key source of liquidity and price discovery during the crisis.”

The IA writes that it represents members who are both investors in, and providers of, ETFs, with their members representing over 90 per cent of the ETF market share in Europe. 

The IA observes that during the early weeks of the crisis in Europe, concerns were raised about ETFs trading in the secondary markets at a significant discount or premium to their net asset value (NAV), particularly in the context of fixed income ETFs, and in particular investment-grade corporate bond ETFs, where 80 per cent saw discounts climb to all-time highs.

“Questions were also raised as to whether this represented a breakdown of the ‘arbitrage mechanism’ by which premiums or discounts to NAV within ETF pricing are usually corrected, and that the discounts were having a distortive effect on the prices of underlying bonds,” the IA says.

It notes that under normal market conditions, fixed income ETFs trade at small differences to NAV, as ETF brokers will price in any difference they see between the tradeable prices of the underlying bonds versus where the index has priced the bonds. 

“But In times of severe market volatility, such as in the outbreak of the Covid 19 crisis in March 2020, where markets have moved at dramatic speeds, these small differences are amplified to a much larger extent and will result in differences between the intraday tradeable price of the ETF (which is based on the live tradeable prices of the underlying bonds) and its NAV (which is using theoretical or stale prices). In some cases, depending on the specific ETF exposure, some fixed income ETFs were seen to be trading at heavy discounts between 2 per cent to 7 per cent below the NAV of the ETF.

“In addition, although bond traders obtain these theoretical bond fair values from pricing services, they have to estimate the value of bonds that are not trading and, as a result, the actual bid price at which they can sell the bonds may be different. This is a typical stress scenario in markets with insufficient liquidity to absorb all of the sell orders in the underlying bond market. It is important that we acknowledge that this is not specific to ETFs, but to how bond market pricing works in its broadest sense.

“This poses the statement that significant tradable disparity between the ETF price and its NAV or fair value, would imply an arbitrage opportunity for Authorised Participants (‘APs’), who can create and redeem ETF shares with the ETF provider.

“When the price of an ETF exceeds the fair value range that is made up of the total costs of buying and selling the underlying basket of securities the ETF is tracking, there is a commercial incentive for APs to arbitrage the difference. This is frequently referred to as the “arbitrage mechanism,” the IA writes.

However, it finds that during the period of market volatility triggered by the COVID-19 crisis, no significant arbitrage occurred and ETF prices remained discounted. 

“Rather than demonstrating a failure of the arbitrage mechanism, it is our view that, instead, it demonstrates that there was no obvious arbitrage opportunity because market participants agreed that the ETF prices were based on the actual tradeable prices of the underlying bonds, whilst conversely, the NAVs represented stale or theoretical prices.

“Therefore, at a time of uncertain, severely stressed and volatile markets, ETFs – and especially fixed-income ETFs – helped to provide continuous liquidity, facilitate unprecedented high trading volumes and provide transparent price discovery for the underlying bond market.”

The IA comments that during the three weeks from February 24th, European ETF trading volumes increased to over two times their average 2019 volumes. European equity ETFs accounted for 30 per cent of all equity trading on the busiest days of this period (compared to 20 per cent on the busiest days of 2019),5 while in fixed income the iShares UCITS fixed income range saw trading volumes double their 2019 average figure.

“High secondary trading volumes continued even as markets started to recover in April. On 9 April, the day the US Federal Reserve (Fed) announced additional stimulus plans and broadened its existing Primary and Secondary Market Corporate Credit Facilities, the iShares USD Corp Bond UCITS ETF traded over nine times the average daily trading volume.

“This increase in trading volume has happened because ETFs have provided a source of liquidity and price discovery when underlying market trading was impaired. In equity markets, at several points during the ETFs proved among the most liquid S&P 500 instruments available, and allowed for price discovery when US equity and equity futures markets were suspended – reminiscent of the role ETFs played when Greek markets were suspended in 2015.”

The IA writes that fixed income ETFs changed hands far more than their underlying holdings, giving unparalleled insight into bond market pricing. 

“As more investors turned to fixed income ETFs, they became indicators of real-time prices throughout the sell-off, as well as through the recovery in April 2020. During the first weeks of the crisis, bond market liquidity became impaired. With little trading data available to provide a reliable on- screen price, on-screen bid prices were often far higher than the firm bid prices market participants were willing to accept.

“By contrast, ETFs were providing real-time pricing and were far more liquid than the underlying bonds – on 12 March the iShares USD Corp Bond UCITS ETF traded more than 1,000 times on exchange, compared to an average of just 37 times amongst its top 5 holdings. This extended through April 2020’s ‘risk on’ period in investment grade (IG) credit. On 9th April the same ETF trading 537 times, while its top five underlying bonds each traded less than 20 times.”

The Association writes that this same dynamic can be seen in the material increase in the secondary-to-primary trading ratio of fixed income ETFs during this period, some of which saw a 270 per cent increase in secondary-to-primary trading activity during March 2020 compared to the 2019 average.

“Again, secondary market trading provided a deeper pool of liquidity even where primary market trading in the underlying securities was less frequent.

“As a result, market participants and pricing services began to use ETFs to essentially estimate the price of those bonds that were not trading. In this way, rather than distorting the price of the underlying bonds, it can be argued that fixed income ETFs were able to keep pace with the bonds that were changing hands frequently and previewed the market-clearing prices of those that traded less frequently, signalling relevant and timely information about where market participants valued corporate bonds in the heat of volatile trading.

“Moreover, there has been a significant reduction in discounts to NAV since the initial volatility spike in March, as bond prices have fallen towards the level of bond ETFs and as ETF prices have responded to central bank intervention.”

Turning to authorised participants, (Aps), the IA comments that concerns have previously been raised by regulators that ETF AP arrangements would break down in times of market stress. 

“However, despite the extreme volatility experienced through the crisis, AP networks appear to have held up well. It has been in the interests of ETF providers, even prior to this crisis, to ensure a well-planned and varied network of APs is in place, and such networks do not appear to have degraded.

“It is also important for investors, regulators, influencers and policy makers to distinguish between APs and other market participants who provide liquidity. While APs are the only firms that can directly conduct creation and redemption business with ETF providers, they are not the only organisations that can provide liquidity. Market makers and broker- dealers also play important roles within the ETF ecosystem and, as with APs, the experience of this crisis, as well as previous market events, is that the withdrawal of one such market participant does not result in serious liquidity impacts on the ecosystem as a whole.”

The IA reports a study from Invesco which illustrates the resilience of AP mechanics during the crisis, despite heightened volatility during the peak of the crisis. The firm had the same 16 APs active during this period as previously. In addition, despite seeing a 50 per cent increase in trading volume between February and March, the top three APs by gross market volume remained in place (albeit with a lower market share). This would suggest that more APs were stepping up to take a proportionately larger trading volume, rather than shying away from trading.

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