Last Updated: 21 March 2023
Last month was far from the first time that bond exchange-traded funds (ETFs) have suffered a sharp sell-off. Notable episodes of market volatility occurred in 2008 and 2010, causing some fixed-income trackers, particularly those in less liquid areas of the market, to register large discounts to their net asset value (NAV) in secondary market trading.
This time round, discounts to NAV have been far smaller than the double-digit percentages recorded by some funds in 2008. As we noted in a recent article, the two largest high-yield bond ETFs listed in the US traded with end-of-day discounts of under one percent during the first three weeks of June.
But concerns about the robustness of the fixed-income tracker fund market persist and bond ETF growth means that far greater sums are now at stake compared to previous spells of market turbulence.
In what was at least a temporary reversal of the recent growth trend, June saw record, $12 billion outflows from US ETFs, with bond funds accounting for two-thirds of the redemptions.
And when one market maker, Citi, was reported two weeks ago to have stopped taking sell orders in ETFs in the US more fundamental questions were asked about the reliability of the process by which exchange-traded funds are created and redeemed.
Citi declined to link its decision to stop processing ETF redemptions to investors’ sales of bond funds. The bank said it had reached capital limits on its US trading desk, with no particular issuers or funds named. In the Financial Times story that first reported the trading halt one Citi trader is said to have told market counterparts that “we are maxed out on the amount of collateral we have out.”
Questioned by IU.eu on the specific role of collateral in the affected primary market transactions, Citi also declined to comment further.
But one trader, speaking on condition of anonymity, told IndexUniverse.eu that “collateral can be involved in a primary market transaction if the exchange of ETF shares for cash or securities is on a ‘free-of-payment’ basis.”
In a free-of-payment primary market redemption a trader sends the ETF shares to the issuer and receives cash or the underlying securities up to two days later. In a free-of-payment creation, the trader sends cash or securities to the ETF issuer and receives the ETF units after an equivalent delay.
By contrast, in a “delivery versus payment” transaction, the ETF shares are exchanged at the ETF’s custodian simultaneously for cash or securities.
“A lot of physically-replicated funds create or redeem shares on a free-of-payment basis,” continued the trader.
Given the time lag between the original creation and redemption order and the ultimate settlement of the transaction, and particularly for larger deal sizes, it’s therefore standard practice for the party that’s awaiting delivery of ETF units or the underlying shares to require the temporary collateralisation of its exposures.
Even though collateralised trades are notionally much safer than those that involve uncollateralised exposures, banks’ risk departments may still set limits for particular counterparties or types of transaction.
Another trader pointed to a possible linkage between Citi’s trading halt and the volumes of redemptions in bond funds, noting that the “delta-one” desks at banks, which process the creations and redemptions of ETFs, are typically located within the equity departments of the banks, and so may not have expertise in handling large fixed-income deals, particularly in less liquid areas of the market.
“Delta one desks are predominantly part of the equity divisions at banks and may not be able to source liquidity in bonds very well,” said Laurent Kssis, partner at London-based trading firm Bluefin Europe. “They would prefer to do redemptions for cash and if cash redemptions have been halted, they are dependent on other bond dealers to unwind positions.”
