Sunday, October 15, 2017

Can We have an ETF Meltdown?

What is the magic that allows us to have intraday liquidity through an ETF on a market that itself trades more or less by appointment?  Case in point: the high yield bond market.  Or emerging markets. Or just about any bond market short of sovereigns and maybe agencies.

Suppose there is a sudden rush for the exits in the high yield bond market. Those in the cash bonds know the drill. They will put in orders with the bank/dealer market makers. For a while those high yield bond trading desks will buy the bonds and hold them in inventory. But it won't take long for the trading desks to reach their capacity. After that point, they won't be buyers. They will act as agent -- also knows as riskless principal -- and look for someone on the other side of the trade. In the meantime the seller has to bide its time. The point is that on the cash bond side, it is not an intraday sort of a transaction. It can take days to find the other side for the trade. And anyone who is active in the high yield bond market knows that, so they structure their leverage and liquidity accordingly.

However, those in the ETFs by and large have no inkling that this is the way the market for high yield bonds works. As far as they can tell, the ETFs trade like an S&P 500 stock. You put in an order to sell, and you are done in minutes.

The reason there is typically high liquidity in the ETFs is that there is typically good two-way flow. And beyond the buyers and sellers are what are called authorized participants. The authorized participants keep the ETFs linked to the underlying cash bonds. They can create ETFs by buying up and bundling the underlying bonds, and they can take in the ETFs and unbundle them and sell the underlying bonds. In a functioning, two-way market, this all works the way arbitrage does for equities indexes. If the ETFs are at too high a price relative to the cash bonds, they grab the cash bonds to create and sell ETFs. If the ETFs are at too low a price relative to the cash bonds, they buy the ETFs and take the bonds to sell in the bank/dealer market.

It sounds simple, but it can't really be foolproof. You know there must be something that can go wrong when you have an instrument -- the high yield bond ETF -- that is as liquid as water even though the bonds it contains are almost the definition of an illiquid security. There is something akin to trying to cheat the law of conservation of momentum. And we all know that anytime something depends on some notion of arbitrage, things can go off the rails. I was in the middle of the portfolio insurance problems that led to the market crash in October, 1987. I knew all about option theory, but when the market was in free fall and the bid-offer spread for the S&P 500 futures was over a dollar, no one was in the mood to try to keep prices in line by doing delta hedging. Options traded in their own world. Implied volatilities were 80% and higher. The option market went into rotation -- trading one stock at a time throughout the day.

For the ETFs, things can go off the rails if the authorized participants can't do their job. If there is not a two-way market, and if the authorized participants' inventory is filled up with ETFs, and if they see that it will take days to get the bonds off of their hands, at the very time that prices are going crazy, they will be stepping away. At that point there is nothing tethering the ETFs to the cash market. The ETF market and the high yield bond market will each trade as their own thing, based on who needs to sell and who is there to buy. At that point it might as well be one market for Martian gravel and another for Enceladian ice cones.

Sure, that is taking it a little too far. There will be some real money investors who will finally step in and keep things from moving into a totally imaginary world. But for the time being the ETF market will, for all practical purposes, shut down. And, getting to the next chapter in this story, it is the "for all practical purposes" that matters.

A clear-thinking, experienced investor in, say, an ETF on an equity market index or gold or currency will not be bothered much by the failure of the high yield bond ETFs. They will get the point that the high yield ETF was creating a fiction of liquidity when there wasn't any, whereas in these equity and currency and commodity markets the underlying markets trade with pretty much the same liquidity as the ETF. But for many investors, all they will hear is that ETFs are in trouble. In the face of the major market dislocation in which the high yield bond problems are likely to be embroiled, people are already going to be in risk-off mode, and if they smell some sort of structural risk with these "newfangled ETFs" they will sell them, period. And there will be plenty of sources out there ready to spread the view that something is amiss.

And, getting to Soros's theory of reflexivity, the changing expectations that come from people in the market buying into this view means that those clear-thinking experienced investors will get out of these more liquid ETFs themselves. And if the authorized participants are still up for doing their job in those markets, that selling will feed back to drop the underlying markets in equities, currencies, and commodities.


  1. Much of this analysis relies on the assumptions (probably correct assumptions) about human reactions in case some or all markets experience stress
    However, ETFs didn't blow-up (or didn't exceptionally tank given market conditions) in 2008-9. The market is larger, but the investor profiles have shifted.
    So an ETF mess depends on 1. How much retail how grown as % of total investors in ETFs since 2008 and 2. How they react if markets are rocky
    For 1. I'd imagine that it has increased - not sure by how much tho
    For 2. Some will probably freak. Whether it's enough to cause 'meltdown'? Who knows.

    1. The assets in all sorts of ETFs have gone parabolic since 2008-2009. Not only asset growth matters, but decimation of active managers as well. They have less assets and those who still do are forced to become a closet indexers in a bull market, or the asset drain will continue. In case of any dislocation there will be much less of that "smart money" coming in to bid things up. Cash levels in all sorts of accounts and funds are at all time lows.

  2. looking at what happened to somew equity ETFs like HDV in August 2015 I would really not be that sanguine about ETFs at large. there many a sharks in the water in the water there, although bond/pref/illiquid stuff is the most ridiculous part of the market.

  3. Interesting analysis....I just googled ETF liquidity and Richard Bookstaber and this is what arrived. Curious timing, I must say. I would like to better understand the nature of the role of authorized participants. If they stop taking orders, and liquidations accelerate, does the Fed then become the default market maker? This whole topic is somewhat uncharted, in my mind, given the unique structure of the AP relationship with the ETFs. Welcome insights. Thanks!

  4. Mr. Bookstaber, I am an options professional and PM for over 2 decades. Your Options book I read in the early 90s at the beginning or my career is still the best of all the books I have read

  5. Any shadow entity provides arbitrage on the underlying, therefore it is not the ETF that freezes, its the market for these things. If there is no price discovery the arbitrageur will assign one, hence providing more continuity in an illiquid market. The ETF is a more efficient price discovery mechanism and it's entirely likely that in a market where there is no supply (buyers) prices will fall. That's how it's supposed to work.