Using ETFs as collateral: will the lessons of August 24th bury that idea?
There has been some recent advocacy of using ETFs as collateral. ETFs are a $3 trillion market, on a par with hedge funds. We recently wrote about some efforts by Markit to identify ETFs with underlying that clearly qualifies as eligible collateral. (See our August 20th post “Are ETFs being neglected as good collateral? Markit thinks so.”) According to Markit “….More than $516bn of ETFs efficiently track assets readily accepted as collateral…”
Well, the August 24th price action in equities may have exposed a fatal flaw in the argument. Of the $516 billion of “eligible collateral” on Markit’s list, $480 billion were equities. ETFs, faced with circuit breakers going off on some of their underlying components and general illiquidity, traded at enormous discounts.
From a August 25th article in MarketWatch “Here’s what may have caused the ‘flash crash’ in some big ETFs” by Victor Reklaitis:
“…The Guggenheim S&P 500 Equal Weight ETF RSP — for example — plunged intraday Monday by as much as 43% before gradually bouncing back…Quite a ride for the $10 billion in investor money parked in the fund…”
“…The prices for The Guggenheim S&P 500 fund, or RSP, and other big ETFs thus dropped far from the market value of their holdings…”
Traders need liquidity in the underlying assets to hedge themselves. Remember, ETFs are derivatives, “a contract that derives its value from the performance of an underlying entity.” Without liquidity in the underlying, traders back away on marking markets. Higher capital costs associated with broker/dealers maintaining inventory and Volcker rule issues are part of the mix too.
A Zero Hedge blog post from August 26th “Was Monday’s ETF Collapse Just A Warmup?” by Tyler Durden channeled Howard Marks “”The ETF can’t be more liquid than the underlying, and we know the underlying can become highly illiquid.” We wrote about Oaktree Capital’s Howard Marks and ETFs in a April 7, 2015 post “ETF liquidity: will it be illusory in volatile markets?”
“…Well, anyone who headed into last weekend still harboring the patently ridiculous idea that somehow exchange traded funds can be more liquid than the assets they reference was subjected to a terrifying dose of reality on Monday morning when suddenly, amid a 1,000 point decline in the Dow, determining NAV became all but impossible in the flurry of tripped circuit breakers and flash crashing mayhem leading to epic and apparently un-arb-able disconnects between fair value and the ETF units…”
Durden quoted a CNN story:
“…ETFs that experienced panic selling are far larger and wouldn’t be expected to have that kind of turbulence. For example, the iShares Select Dividend ETF (DVY) plummeted as much as 35% at its lows…. That’s a stunning move considering this BlackRock (BLK)-backed ETF is worth over $13 billion and is focused on stable American stocks that have a long history of paying dividends…None of this ETF’s top holdings — like Lockheed Martin (LMT), Philip Morris Internationa (PM) and McDonald’s (MCD) — suffered losses north of 11%…”
So should a derivative of an eligible collateral be treated just like the eligible asset? If you are depending on the value in the derivative ETF as collateral to mitigate other exposure, it might be time to think twice about that strategy. ETFs depend on the kindness of strangers — the market makers who, in normal times make a small spread trading the underlying assets and the ETFs against each other, but when faced with volatility, protect themselves by widening out markets. As more trading heads to an agency model, the situation will only get worse. ETFs can be exchanged for the underlying assets, but it is an added step with performance risk. For anyone on August 24th holding the Guggenheim S&P 500 Equal Weight ETF as collateral, seeing the 43% intra-day drop had to be an outer-body experience they prefer not to repeat.
February 22, 2017
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