The UK Financial Conduct Authority said exchange-traded fund primary markets are highly concentrated, particularly for fixed income ETFs, but there is evidence that alternative liquidity providers ’step in’ during times of market disruption.
Andrew Bailey, FCA
The UK regulator, led by chief executive Andrew Bailey, released a research note this month, Fixed income ETFs: primary market participation and resilience of liquidity during periods of stress.
The FCA decided to research fixed income ETFs due to the rise in passively-managed funds from 8% of global assets under management in 2007 to 20% in the following decade. As a result of this growth concerns have been raised about potential risks to financial stability from fixed income ETFs. They may have a greater risk of liquidity mismatch as they are traded daily while investing in relatively illiquid underlying bond markets.
“Everyone recognises that low fees and easy access to liquidity are positive features that underpin the success of ETFs,” said the report. “However, questions have been raised as to whether ETFs would still be able to offer the expected level of liquidity in times of market stress, and the potential financial stability consequences if not.”
The FCA analysed a database of ETFs domiciled in the European Union from a sample of ETFs managed by four of the largest global issuers. The dataset covers daily creations and redemptions for 257 ETFs with $381bn (€342bn) in assets under management between 2016 and 2018. Fixed income ETFs were the second largest category after equities and contribute approximately 18%.
The FCA’s analysis of Bloomberg data showed that more that half of these funds were invested in investment grade instruments. The regulator also found that fixed income ETFs accounted for a similar level of aggregated trading volumes to equity ETFs, despite their lower assets.
“A possible explanation for this is that investors use fixed income ETFs to manage their exposure to the asset class as a whole,” continued the FCA. “In other words, while it is easy to manage the exposure to stocks by trading them directly, it is relatively easier to manage exposure to fixed income products by trading ETFs.”
The UK regulator found there is a high level of concentration amongst authorised participants (APs), who create or redeem ETFs in primary markets.
“The five most active APs are responsible for about 75% of overall reported primary market volumes (across all asset classes),” said the FCA in the report. “Concentration is particularly pronounced in the fixed income market, with the top five APs there accounting for around 91% of overall volumes and the top AP itself accounting for 51%.”
However the FCA also observed that after various stress events with a marked rise in fixed income redemptions, there was an expansion in the overall number of APs active in fixed income ETFs and a decrease in concentration amongst the most active APs in fixed income ETFs.
“We also observe a similar pattern in equity ETFs in 2018 stress events," added the FCA. “Our analysis therefore provides tentative evidence that alternative liquidity providers step into the market to some extent during times of stress.”
The regulator has not analysed why this happens, but said it is possibly due to arbitrage opportunities that emerge from the selling pressure in the secondary market during times of market stress. ETFs may trade at a discount to the value of the underlying, making it profitable for less active APs to enter the market and provide the necessary liquidity.
The report concluded that this analysis is just the first step in investigating the resilience of ETF markets.
The FCA concluded: “Resilience is a particular concern for ETFs with less liquid underlying assets, so we will also be extending our analysis to this aspect of fixed income ETFs.”
European ETFs
Assets in ETFs and ETPs listed in Europe reached a record at the end of last month according to ETFGI, an independent research and consultancy firm covering trends in the global ETF/ETP ecosystem.
https://twitter.com/etfgi/status/1161624012813996032
ETFGI reported yesterday that July marked the 58th consecutive month of flows into European listed products with net inflows of $18.55bn, bringing year-to-date net inflows to $62.74bn.
Fixed income ETFs/ETPs listed in Europe attracted net inflows of $38.33bn, far more than the $8.48bn in net inflows in the same period in 2018. In contrast, equity ETFs/ETPs had inflows of $16.67bn, substantially less than the $24.51bn in the first seven months of last year.
Deborah Fuhr, managing partner and founder of ETFGI, said in a statement: “Despite the weak performance for European equity markets and the intensified trade dispute between US/China, the prospects for further loosening in monetary policy by Federal Reserve and European Central Bank led the European equity ETF/ETPs to see significant inflows of $9.97bn in July, and fixed income funds see net inflows of $6.57bn.”
