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Are ETFs truly to blame for causing market stress?

Investors looking for potential causes of volatility in the debt markets have nothing to fear from ETFs, according to one of the industry’s largest market makers.

These products have become something of a boogeyman for some debt investors who worry that a mismatch between their liquidity and that of the securities they hold could exacerbate a credit sell-off. But a new report from Jane Street concludes that such concerns are unfounded.

“While credit ETFs will become more costly to trade in a stressed market, they don’t pose a systemic risk,” Andrew Upward, an ETF strategist at the firm, wrote in a paper dated July 23. “Nothing about the structure of credit ETFs per se suggests they will be the cause of disorderly trading in the underlyings.”

Vanguard, Blackrock and State Street have 83% of U.S. ETF assets, 50% of total ETF revenue and own the 50 largest ETFs.
A trader works on the floor of the New York Stock Exchange (NYSE) in New York, U.S., on Friday, May 5, 2017. U.S. stocks fluctuated with the dollar and Treasuries as a rebound in hiring added to optimism that the economy is on firm footing, boosting speculation the Federal Reserve will raise interest rates. Photographer: Michael Nagle/Bloomberg

ETFs have been decried over the years as everything from a Marxist subversion of capitalism to a weapon of mass financial destruction that will bring on the next crisis. But while debt investors’ anxiety has typically revolved around how these funds will respond to large, sudden withdrawals, skeptics are now homing in on secondary trading in the $750 billion market for U.S. bond ETFs, and questioning whether users fully understand how the securities behave in times of stress.

In that respect, Jane Street’s full-throated defense is hardly surprising; the company trades $1.6 billion of debt ETFs every day, according to a letter to the SEC last year. But competition between electronic brokers for those trades is one reason why debt ETFs aren’t a serious threat, according to Upward.

When ETF sellers push the price of a fund below the value of its holdings, market makers like Jane Street buy the ETF shares and swap them with the ETF manager for the underlying bonds. Known as a redemption, the market makers can then sell the securities for their higher price, booking a small profit.

Fixed-income products designed to minimize interest rate risk are among the leaders.
July 24

Specialist traders have built entire businesses on this arbitrage, using superior speed and technology to edge out many of the banks that used to dominate. So if prices of either the funds or bonds look to have fallen too far, too fast, market makers may calculate that it makes sense to hold onto them and look to sell when prices recover, wrote Upward. Put simply, they have an incentive to stay in the game, rather than blindly feeding a slump.

Instead, ETFs could actually rein in a bond rout, as market makers facing a less liquid credit market will pass on their higher costs of trading to investors wanting to sell. While that could take some by surprise, it also discourages excessive selling, wrote Upward.

“If selling the underlying bonds is difficult or expensive, selling ETFs will become expensive, too,” Upward said. “By lowering their ETF bid prices, market makers discourage further ETF selling. One can think of it as the ETF market’s last-resort mechanism for resolving the liquidity mismatch problem. Meanwhile, ETF investors who very urgently need to sell can still do so.”