Fixing The Plumbing

Matt has raised some major questions about the future of ETFs and ETNs in the wake of the huge bailout of the banking sector. I’m going to reflect on those for a little longer before replying … at least for a few paragraphs.

In the meantime, there are some urgent things to cover. What about the faulty plumbing in the markets? I mean the crazy discounts to index values that opened up in the US ETF market over recent days, which Murray Coleman wrote about yesterday, and which are not supposed to happen. We learn in our first primer on ETFs that the arbitrage process which underlies in-kind redemption and creation is supposed to eliminate any such price discrepancies. Shouldn’t market-makers have been climbing over each other to make risk-free profits?

Earlier today, I spoke to Paolo Giulianini, head of ETF trading at UniCredit in London, to get a European perspective on things. He confirmed that the discounts to index values that we have seen in US corporate bond ETFs have been mirrored this side of the Atlantic (even though by today, Tuesday, they have begun to disappear). But, he added, liquidity problems don’t stop there—they have affected even some benchmark equity ETFs.

If one looks purely at reported trading volumes, he said, things look fine, but actually placing a trade in the NASDAQ 100 futures in a market maker’s size – 100, 500 or 1000 contracts, for example—has been difficult to achieve in recent days without moving prices significantly. So, while arbitrage should in theory prevent ETFs from trading at discounts and premia from the index value, in practice it has been difficult to move them back into line.

And, on the subject of plumbing, I noticed this story on the FT Alphaville site earlier today. If you need to actually trade in ETFs, a number of UK-based stockbrokers—Barclays Stockbrokers (named in the article) and Selftrade, TD Waterhouse, HSBC, Lloyds TSB (named in the comments)—are apparently doing a very poor job in answering their telephones or getting their online trading systems to work.

So if you’re an ETF investor, not only do you have to cope with the worst week in history for the US stock market, you may have inexplicable discounts to cope with, and your broker may not allow you to trade anyway. It feels as though major repairs need to be done to make sure the market’s infrastructure actually works. Now where did I put those Krugerrands?

Which brings us back to the bailout and Matt’s questions. When I wrote two weeks ago that I saw a bleak future for ETNs, I meant that it was no longer possible to price these instruments without making a big adjustment for counterparty risk, and that the Lehman default (whose repercussions are still spreading) may well have made them unsellable anyway. Clearly the huge taxpayer injections to the banking system will have some effect in reducing risk premia, and in the case of nationalised entities, default risk will have fallen sharply.

But investors are going to be paying a great deal of attention to fund structures, and collateralisation is going to be demanded in most cases. Since their default risk is now the lowest, perhaps only the state-owned banks should offer ETNs? I can see it now—the RBS/Northern Rock/Bradford and Bingley/National Savings “Gordon” ETN programme…

And I think we’re still all waiting to see how the bank bailouts work out. We’ve already seen unexpected, unpleasant and unplanned side effects from previous state interventions. If the massive increases in public debt cause a rise in government bond yields, then the economic downturn could intensify, with knock-on effects for everyone’s ability to repay loans.

In response to your other questions, Matt, I think that investors will demand a lot more transparency from ETF providers on all areas of fund operation, from securities lending to swap policies. As to whether swap-based ETFs or in-specie ETFs are the way forward, that’s the million-dollar question—and I’m going to sit on the fence on that one!

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