The inside story of how ETFs weathered the March 2020 storm

As the markets entered the shock of Covid-19 in March 2020, anyone familiar with how exchange-traded funds worked braced for bad news – but it never happened.

There were alarming signs of stress – the prices of many corporate bond ETFs have fallen significantly below the net asset value of their holdings, raising fears that investors completely lose faith in the structure of the fund and part with their assets.

But even when liquidity had dried up in their underlying constituents, ETFs, with the notable exception of the US Oil Fund (USO) and some leveraged products, continued to trade.

“The consistent theme at the start of Covid is that we were all looking for a problem, but problems weren’t happening,” said Matteo Andreetto, head of SPDR ETF Business, Emea, for State Street Global Advisors.

Today, when market participants are asked to recall what happened during those frenetic days, a striking theme emerges – besides their technical force and massive central bank support led by the US Federal Reserve, one of the most important factors that helped ensure that the ETF market continues to function was clearly the people themselves.

“The business is built on personal relationships and that’s why it works,” said Reggie Browne, known as the ETF Godfather and who heads the ETF market making business for trading company GTS.

On the New York Stock Exchange, Level 1 circuit breakers, triggered when the S&P 500 fell 7%, tripped four times in eight trading days between March 9 and March 18, halting trading for 15 minutes at every time.

Douglas Yones, Head of Exchange Traded Products at the NYSE, recalls a huge effort to make sure everything went smoothly and to ensure that participants were prepared for the vast volume of transactions that would hit the markets as soon as possible. the circuit breakers would trip. “We picked up the phone and called every market maker and every liquidity provider and said, we’re going to hit the breakers, are you ready? “

How ETFs Work

Creation: ETF providers and authorized participants cooperate in the creation and redemption of ETF shares, monitoring their offering and ensuring that ETFs trade near their net asset value. PAs “buy” an equity creation unit from the provider with a “basket” of underlying securities, and then release the shares in the secondary market.

Redemption: If demand for shares of an ETF decreases, the AP may acquire the value of a repurchase basket of shares in the secondary market and pass them to the provider in exchange for the underlying securities.

How bond ETFs differ: Bond ETFs have “personalized baskets” published by the provider each day that only contain a selection of the underlying bonds.

What is for authorized participants: APs make money from the difference between the price of the securities and the ETF.

The problem, as Dan Izzo, Managing Director of Market Maker GHCO, pointed out, was the potential loophole in the functioning of the ETF ecosystem (see above), especially for bond ETFs.

“As each AP was trying to redeem at the same time, ETF providers had to restrict trading in custom bond baskets to make sure they didn’t deviate from their index and dealt with everyone. fairly. This meant that PAs and market makers could get stuck with certain bonds, illiquid at the time, that they couldn’t trade when they bought back ETF shares.

Yones said phone calls were also made to ETF issuers asking if they were changing the size of their baskets and asking bond ETF providers what changes they were making to their baskets.

Above all, Yones explained, after years in the industry in a variety of roles, the people he called were mostly friends, which meant they had established trust and an excellent understanding of each other.

Across the Atlantic, at the London Stock Exchange, things were just as stressful, but again human intervention helped make things work.

Line chart of the S&P 500 Index showing the fall in US stocks in March 2020

“We spent a lot of time on the phone with our ETF issuers and market makers,” said Lida Eslami, business development manager for exchange traded products at LSE.

On March 13, in response to growing concerns about volatility in the underlying markets, the LSE issued an advisory confirming that the bid-offer spreads cited by market makers could expand up to a maximum of 5 percent on all Fixed Income ETFs.

Three days later, a new notice confirmed that the spreads could widen to 5 percent on all exchange-traded products.

The efforts were gratefully received. “I have never felt so taken care of in my career,” said Izzo, who recalls being in constant contact with the LSE as well as the major ETF providers.

At index provider FTSE Russell, Managing Director Arne Staal said staff were preparing for a major rebalance when the pandemic struck and they had to try and do their jobs from “the kitchen table. “.

With $ 18 billion tied to the FTSE Russell indices, including $ 1 billion in ETFs, and plummeting markets, the job has been particularly stressful.

“We had to assess whether the rebalancing would exacerbate the market turbulence,” Staal said, adding that there was ongoing dialogue and late-night phone calls with all major parties, including regulators, banks and large asset managers.

“You’ve reached the point where you just have to make a decision. Said Staal. Eventually, FTSE Russell rebalanced its equity indices, but after careful consideration decided to postpone rebalancing its fixed income portfolio.

Some industry players insist that the technology supporting ETF trading was still crucial.

“You have to be prepared for the unknown, which means creating systems that can handle a 100-fold increase in transactions,” said Dennis Dijkstra, Managing Director of Flow Traders.

However, Glenn Havlicek, CEO and co-founder of GLMX and former head of global liquidity management for JPMorgan, said that while “transaction efficiency” was crucial, “a lot is happening behind the scenes.”

For example, Stefan Kaba-Ferreiro, head of trade with GHCO, said that some ETF providers have helped by selling some of the bonds on behalf of the PA, thus delivering, upon redemption, a basket of bonds and cash from the sale, instead of just bonds.

So what made ETFs successful in March 2020? Some, like Kaba-Ferreiro, continue to claim that it was the Fed, rather than the technical strength of the envelope, that made the difference. “I found it very interesting because everyone announced the success of ETFs during this period,” he said, but added that there had been unprecedented political intervention by the government. “We haven’t really been able to test the product,” he said.

But even though Kaba-Ferreiro is right about the importance of the Fed, as Havlicek pointed out, even that decision was not automated. “In the end, it was a human decision,” he said.

This human factor may seem troubling to some, but industry veterans insist it helps explain the resilience of ETFs.

“The fact that [some of what happens in the primary market] is discretionary might be seen as scary by some investors, ”said Tony Kelly, co-founder of BondBloxx and an industry veteran whose 20 years in the ETF industry have included services with Goldman Sachs, BlackRock and BGI.

However, he maintained that the ETF ecosystem was part of his strength.

“It’s a unique structure in that even though the primary market participants act in their own best interests, it’s actually for the good of the little guy. “

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