A new Finadium report looks at liquidity and operational risk in the ETF market given recent changes in underlying market liquidity and volatility, as well as regulatory concerns about fire-sale risk. We explore how market participants can work together in solving some of the complex market structure problems that have arisen in the current environment.
The ETF market has doubled in size from 2010 to 2015, a testament to its attractiveness to investors. ETFs are also emerging as a focal point of concern for regulators and market participants looking at liquidity, volatility and systemic risk. Are ETFs truly a new form of risk, and if so how should market actors respond?
As a derivative product, ETFs share the characteristics of other derivatives, including a close relationship to the trading and liquidity patterns of their underlyings. A rush to sell ETFs or options on ETFs could in turn lower prices on underlying securities, which could then turn into a panicked fire-sale of the market. This fire-sale risk could occur not just from market sentiment but also due to operational errors that allow for mispricing of index tracking products; while short-lived, this has already occurred in practice. Fire-sale risk is a fundamental concern and one that requires careful consideration of how to disconnect the chain of risk transmission for the benefit of all parties.
Regulators will be focusing on ETFs in 2016, that is for certain. The growth of ETFs, a derivative, as well as the large volume of options trading that now accompanies them, mean that regulators see a potential problem. ETFs are attractive for reasons of simplicity, cost and convenience. The liquidity and volatility of their underlying markets are not what they used to be, however, which magnifies the need for some as yet undefined form of intervention.
This report should be read by financial market professionals including ETF managers, trustees, market makers, portfolio managers, traders, operations, technology and product development teams. The report may also be useful for regulators and legal advisors at ETF managers.
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