Paul Justice, an ETF strategist with Morningstar, pondered the causes of the May 6 ‘flash crash‘ in a recent article for the investment research firm.
His analysis paid particular attention to the role of exchange-traded funds in the sell-off, largely because ETFs made up over 70 per cent of the securities with cancelled trades on the day.
But Justice did not conclude that these funds were responsible for the trading abnormalities. Instead, Justice hinted that the reason why ETFs were disproportionately affected had more to do with the market makers and authorised participants (APs) charged with providing liquidity to the funds — as part of the ETF tracking mechanism — than the funds themselves.
As he noted (emphasis FT Alphaville’s):
ETFs are no longer the product of a cottage industry that can accept such inefficiencies, even if the majority of their investors were not directly impacted and the blame lies with a third party. This is a trillion dollar industry whose promising future is predicated on the influence it can impart on its market participants in an immediate and definitive fashion.
Much can be learned from the situation, wrongs can be made right, and the industry can emerge stronger than before. We expect the product providers to take a leadership stance in promoting a more efficient marketplace, and we believe they should start with the Authorized Participants and market makers that so often make a profit providing liquidity during periods of normalcy.
If those parties are going to be paralyzed in the face of adversity, then the product suppliers will have to qualify every statement they make regarding the liquidity and price efficiency of ETFs.
Which, in other words, means the ‘flash crash’ may have shown ETFs to be particularly vulnerable in the event large sell-offs and liquidity lapses precisely because of their structure’s dependence on market makers and authorised participants.
No definitive research into the biggest names operating in this area, however, has ever really been conducted (at least, we haven’t come across any – do let us know in the comments if we’ve missed some essential reading).
And considering that ETFs are supposed to uber ‘transparent’ products already, it’s actually pretty hard to get hold of authorized participant names associated with individual products — you usually have to make direct requests to ETF providers on a case by case basis. Prospectuses, more often than not, do not identify APs from the onset.
Sporadic reports, however, suggest it’s actually only a handful of institutional names that are linked to the AP role in the US, and about 40-50 more obscure electronic trading firms that fulfil the market making function — as and when they please, we might add.
Electronic high frequency ‘market makers’ are drawn to trading ETFs because of the potential to make frequent small profits from index arbitrage.
An interview conducted by ActiveETFs with Paul Weisbruch, the VP of ETF/Index Sales and Trading at Street One Financial — a so-called ETF liquidity provider — presents some interesting insights.
For example (our emphasis):
You mentioned the term “authorized participant”. Is there a difference between a “market maker” and an “authorized participant”?
Paul: Yes, there’s a fine distinction between the two. Some authorized participants may not be market makers in a given ETF. And some market makers may not be authorized participants (APs), that’s one caveat. However, there are some firms that act as both market marker and authorized participant.
Really, it varies from firm to firm and ETF to ETF. Both participants though are essential to the liquidity and the open-endedness of ETFs and the mechanics that make them trade efficiently.
Authorized participants are the ones who can actually trade the underlying basket versus the ETF itself and then they would convert those to new shares and vice versa would redeem them if someone was coming to them with a sale.
So they actually have permission and have gone through a filing and paperwork with the ETF company themselves, whether it be iShares, ProShares, First Trust, what have you, to have permission to be an AP.
So there’s a handful of APs out there and mostly they are the large banks – the usual suspects like the Merrill Lynchs, the Morgan Stanleys, Fortis Bank, Goldman Sachs, firms like that tend to be the APs.
Market makers, however, there’s a large number of market makers that are not APs. I would venture to say 40 if not 50 firms, that you probably haven’t heard of because they are basically electronic, prop-type trading market makers.
They’re very active in the underlying liquidity of ETFs, they are making two sided markets, bid-ask, and sometimes they’re just waiting for someone to come to them with an order and they’ll price it for you. Again, they have little interest in the whole creation/redemption process because they’re just trading, looking for small inefficiencies, trying to trade the underlying versus the actual ETF shares that are out there in the market.
And the following:
The ETFs still though have a bid/ask spread. So what does the size of that bid/ask spread depend on for an ETF? When would it widen?
Paul: It generally widens when there’s a lack of market makers watching the product and you’ll see this on newer ETFs. ETFs do require a certain amount of seasoning for the market maker community. Not every market maker will jump into a product and make markets actively on day one. So therefore you might see a 10 cents wide spread in a newer ETF because maybe there’s only a handful of market makers in it while in SPY and IWM, there may be hundreds of participants actively involved in it and watching it all day long.
But make no mistake, just because it has a wide spread does not mean it can’t be traded effectively. That bid-ask spread should be around the real NAV or IV of the fund at any given point of the day and that’s what’s important to understand. The bid-ask is not necessarily what you’ll pay or what you’ll sell for if you have an order. It’s kind of a framework around the actual IV(indicative value), so if you trade intelligently, use limits, have some idea what the NAV or IV is, you should generally do better than the actual bid-ask.
Understanding that ‘behind the scenes’ process helps to explain why ETF share prices went so uniquely haywire when liquidity lapsed and so-called ‘predatory market makers‘ disappeared from the market.
From now on, one might presume ETF providers would consequently be under pressure to stress-test their products against such potential liquidity lapses, and to disclose the findings to investors.
As Justice put it in his note, every statement pertaining to liquidity and price efficiency really needs to be qualified to investors.
More complete and active disclosures about funds’ authorised participants might also be of interest.
Related links:
When is a market maker not a market maker? – FT Alphaville
How ETFs fueled high frequency trading - FT Alphaville
ETFs and the ‘flash crash’ – FT Alphaville