IMF warns role of market makers in ETFs ‘requires close monitoring’

Two APs claim 90% of the business of the largest ETF issuer

The International Monetary Fund (IMF) said the Central Bank of Ireland (CBI) should encourage ETF issuers to use more liquidity providers to ensure these relationships can withstand market stress events. market.

The international policymaker said the role of liquidity providers poses a key risk within ETFs, as only authorized participants (APs) have direct access to ETFs for creation and redemption activities, while market makers can withdraw at any time from providing liquidity.

He added that the CBI’s work had already identified concentration risk within the liquidity provider space, with just two players responsible for up to 90% of AP activity for some ETFs from the largest issuer. European BlackRock.

Additionally, while there is no evidence that market makers walked away from the market during the volatility of COVID-19, the IMF said this is an area that “requires monitoring. narrow”.

He said: “Relevant central bank oversight teams should engage with ETF providers to ensure that their agreements with APs and market makers are robust and support the smooth functioning of the sector, including in times of market stress.

“There should also be closer cooperation between investment fund supervisors and colleagues overseeing APs and market makers.”

Apart from liquidity providers, the IMF has also identified price discount risk – the difference between an ETF’s market price and its net asset value (NAV) – as another area of ​​focus.

He said this risk materialized during the COVID-19 disruption, when the disparities between the share price of some fixed income ETFs and the value of their assets reached 17%, although these discounts have usually gone within a week.

However, regulators and industry bodies such as the International Organization of Securities Commissions (IOSCO), the Bank of England and the Bank for International Settlements were quick to point out that the March 2020 volatility underlined to how ETFs were a source of price discovery for investors as bonds did not trade.

Interestingly, the CBI published a white paper in 2020, titled Information and Liquidity Links in ETFs and Underlying Markets, which found that the close information links between ETFs and stocks create potential of “illiquidity contagion” during ETF demand shocks – as both are exchange-traded – while over-the-counter (OTC) bonds are less susceptible.

However, ETF industry participants said the CBI failed to consider the role of the secondary market in providing an additional layer of liquidity for ETFs.

The IMF also highlighted the potential for settlement delays given that ETF trading is fragmented, but said much of this had been mitigated by the migration of all Irish-domiciled ETFs to the ICSD model. after Brexit.

The policymaker’s comments on ETF trading follow IOSCO’s draft of its latest set of ETF best practices in April, which also stressed that ETF issuers should “execute due diligence” on PAs. and market makers and avoid exclusive agreements with individual liquidity providers.

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