The UK’s Financial Conduct Authority has come out in support of ETFs amidst a debate as to whether ETFs, particularly fixed income products, could exacerbate financial instability during periods of market stress.
The FCA found that liquidity in the primary market for ETFs has historically been resilient during bouts of market uncertainty.
In a research note, the UK regulator investigated the functioning of primary market ETF trading at times of heightened selling in the secondary market to ascertain whether ETFs would still be able to offer the expected level of liquidity in times of market stress.
The primary market refers to the in-kind creation-and-redemption mechanism, conducted by Authorized Participants (APs), by which ETF shares are brought into and removed from the market. The secondary market refers to the trading of ETF shares between investors.
The investigation, which was based on a dataset of primary market transactions for a sample of 257 Europe-domiciled ETFs managed by four of the largest global issuers, found that there is a high level of concentration among APs with the five most active APs responsible for about 75% of total primary market volumes across all asset classes.
Within fixed income, which has been a key point of concern due to the potential liquidity mismatch in ETFs that invest in relatively illiquid underlying bond markets, the investigation found that concentration is even more pronounced. The top five APs active in this segment account for around 91% of overall volumes and the top AP itself accounts for 51%.
The FCA tested whether the functioning of these primary markets was impaired during notable stress events. In particular, it looked at the period of US Presidential Election in November 2016, during which the total volume of redemptions increased substantially from around $100m/day (5-day moving average) to around $500m/day.
It found that the number of APs active in the days leading up to and following the US Election increased significantly, from an average of around three in October to an average of around six in the two weeks following the election. The FCA deduced that other (i.e. typically less active) APs became active in the market during this period of stress.
The FCA also looked at AP market concentration around this time. It found that the combined market share of the three most active APs declined following the stress event (US election), from around 95% total volume of redemptions to around 85%. Again, the investigation concluded that other APs became more active, suggesting that typically less active APs absorbed a relatively higher proportion of redemption volumes.
Taken together these results suggest that, despite the primary markets being highly concentrated, lower-activity APs can ‘step up’ and act as alternative liquidity providers in times of stress.
The FCA surmised that arbitrage opportunities must emerge from the selling pressure in the secondary market during times of market stress – which likely results in the ETF trading at a discount to the value of the underlying – making it profitable for less-active APs to enter and provide the necessary liquidity.
In conclusion, the FCA found that while ETF primary markets are highly concentrated, particularly so for fixed income ETFs, evidence suggests that alternative liquidity providers step in during times of market stress, ameliorating concerns about liquidity resilience.
In the course of its investigation, the FCA did not detect any other behaviour that would raise concerns for financial stability.