With the benefit of hindsight, the prevailing view is that it was the relatively liquid ETFs that were trading at fair prices, and that many of the underlying bonds were simply not changing hands and were thus being quoted at stale, unrealistically high, prices. In this version of events, ETFs were the good guys, offering a tool for distressed sellers who needed to exit, or at least hedge their exposures, while also allowing bargain hunters to step in and steady the market.
However, during a crisis, when many investors are rushing for the door, redemptions hugely outweigh creations. In that scenario, if a bond is included in the basket, the APs “may then become reluctant to purchase more of the same bonds, reducing their liquidity,” the paper said. The paper comes after both the International Monetary Fund and the Bank for International Settlements raised questions about the impact of ETFs during stressed markets.
If the issuer agrees to that trade, by day two, it is increasingly desperate to get rid of some of the illiquids, as the ETF’s tracking error to its underlying index may be rising. The share of illiquids in its desired redemption basket might thus rise from 20 to 40 per cent.