Trading At The Margin


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Exchange-traded funds work by engaging specialised intermediaries (so-called "authorised participants" or "APs") to exchange the shares or bonds in an ETF's underlying index for the ETF shares themselves. Such "creations" of ETF shares take place in standardised units, often worth a few million dollars each. When the AP returns ETF shares to the issuer in the reverse process, a redemption, he receives the index shares or bonds, leaving him where he started.

For a liquid equity ETF, the constituents and constituent weightings of the creation "basket" supplied by the AP to the ETF issuer are pretty much identical to those of the index itself. Look into the creation basket of an S&P 500 or Euro STOXX 50 ETF, and you'd see the index in microcosm, in other words.

But for ETFs tracking less liquid indices or asset classes, the creation and redemption process has never been that simple.

"When we wanted to create a unit of iShares' MSCI World ETF in the early 2000s, we had consistent problems delivering the less liquid 'tail' of index stocks, and this regularly caused the whole creation process to fail," one former ETF trader told on condition of anonymity.

The MSCI World index contains around 6,000 stocks from 24 countries.

"The penalty for a failed settlement on a large stock basket was US$30 per stock, and that's before counting the funding costs for delayed settlement and potential buy-in penalties levied by clearing systems. As a result it was extremely expensive to fail an ETF creation. So we worked with iShares to develop a new methodology:cash creation," said the trader.

In a cash creation, the AP delivers cash, rather than the index securities, to the ETF issuer. The task of buying the right index constituents then becomes the responsibility of the issuer, which charges APs a variable spread (usually expressed as a percentage of the fund's net asset value) to cover the costs of acquiring the necessary stocks or bonds.

As well as being used in the traditional (physically replicated) ETF model for less-easy-to-track underlying benchmarks, cash creations (and redemptions) then became the norm for the synthetic ETFs that boomed in Europe after the mid-2000s.

As a synthetic ETF doesn't actually own the stocks or shares in the index being tracked (instead, it owns a "substitute basket" of unrelated securities, or holds collateral under a pledge agreement with a derivatives counterparty), there's no obvious need for an AP to supply the index constituents to create a fund unit, and cash creation is the usual practice for such funds.

But the old model of an AP delivering the index shares or bonds to the ETF issuer has evolved as well. In so-called "custom" or "negotiated" basket creations, what the AP actually delivers to the issuer to obtain fund units is the result of often protracted discussions between the two parties. Creations may also involve a mixture of index securities and cash.

And, far from the origins of the like-for-like exchange model used for the first ETFs, some creation baskets may contain only a much reduced version of the index, particularly in the market's less liquid areas.

Creation And Redemption Baskets

The managers of State Street's SPDR US$12 billion Barclays Capital High-Yield Bond ETF (NYSE Arca:JNK), for example, use distinct creation and redemption baskets to manage inflows and outflows , each consisting of only a subset of index names.

"Our portfolio managers use the creation and redemption baskets to manage the fund's weightings against the index," James Maund, a New York-based member of State Street's global capital markets team, told in a telephone interview. "Each day we send out a file to APs specifying a list of bonds for fund creations, typically 40-60 bonds long, and a different list of similar size for redemptions. The size of the list can vary from day to day."

The Barclays High Yield Very Liquid index tracked by JNK has a substantially larger number of constituents, 234 in total. JNK currently holds 252 bonds, according to the SPDR website.

But, depending on market circumstances, the actual creation and redemption baskets used by State Street for JNK may be much smaller, adds Maund.

"The best way of describing the creation and redemption process is to say that the daily lists we publish act as a kind of "menu" or a starting point for negotiations between the fund manager and the fund's APs," Maund told

"From the list of 60 bonds the portfolio manager may choose to bring in, for example, eight bonds to create the fund. We set a maximum notional value for each bond as part of the creation basket:for example, half a million dollars each in a typical creation basket size of US$4 million," Maund explained.

Using creation baskets that are restricted in the number of securities held and which consist of round-lots of individual securities, typically half a million or a million dollars in each name, reflects trading realities in the corporate bond asset class, says Peter Tchir, founder of FT Market Advisors and a former investment bank credit trader.

"Unlike in virtually every other market, if you ask for a price in a smaller trade size in high-yield corporate bonds, the bid-offer spread increases," Tchir told

"So, for example, on a typical bond issue from Chesapeake Energy ( CHK ), the bid-offer spread on a US$1 million transaction might be 1 percent of par value, but for a smaller order the spread might be 3 percent or more," Tchir explained.

Index Effect Pronounced In Corporate Bond Sector

Concerns over valuation distortions apparently caused by the growing volume of money in index-tracking funds are not new. However, the "index effect" of ETFs may be particularly pronounced in the corporate bond sector.

In a recent research publication ("the ETF Bid") analysts at Goldman Sachs showed that the performance of the constituents of JNK's close competitor, iShares' US$16 billion iBoxx $ High Yield bond fund (NYSE Arca:HYG) has become increasingly detached from that of the rest of the high-yield bond sector since 2009, as inflows to the fund have soared.

And in a report published last month, researchers from BlackRock's investment institute cited evidence from credit trading platform MarketAxess, showing that in the first quarter of this year the share of the top 2 percent of investment grade bonds by volume rose to almost a third of overall corporate bond trading, while trading in the top quintile of bonds by volume accounted for 93 percent of total corporate bond turnover.

However, says BlackRock, corporate bonds' overall liquidity continues to suffer as the market's investment bank dealers, the traditional middlemen of the sector, cut their inventories in response to increasingly burdensome regulatory and capital constraints.

"The [corporate bond market's] liquidity is bunched up in large new issues," says BlackRock. "Poor liquidity is depressing overall trading-even as yield-hungry investors bid up prices and companies take advantage of historic low financing rates by issuing more debt."

The firm is attempting to provide its own solution to the liquidity problems created by the withdrawal of investment banks from the corporate bond market, recently testing a new bond trading platform to allow traders to "cross" orders with each other or to match trades against BlackRock's own internal order flows.

However, the platform's details remain sketchy, and BlackRock declined repeated requests from for an interview with the firm's head of bond trading, Richard Prager.

Other asset managers may set up a competing version of a centralised bond trading venue, according to a June report in the Wall Street Journal , possibly in conjunction with investment banks.

The increasing concentration of bond trading in a few selected corporate names may cut both ways. On the one hand, it allows ETF prices to be set on the basis of the marginal pricing of the most liquid index securities, permitting secondary market ETF traders to set wafer-thin bid-offer spreads in funds like HYG and JNK during an average day's trading.

HYG, for example, often trades in the secondary market with a bid-offer spread of 1-2 cents on current fund price of around US$92, compared with an average bid-offer of 100 basis points in the underlying bonds.

But in a stressed market, the dislocation potential may increase. State Street told that while a typical bond ETF creation or redemption may be the result of a negotiation with its APs, it has the final say over what comes into or what goes out of the fund.

An unintended consequence of this may be that, during a period of rapid redemptions, APs will end up receiving bonds they hadn't requested, potentially driving ETF secondary market prices down very quickly.

"If traders suddenly start receiving less liquid bonds from the ETF, such a scenario would accelerate moves to the downside," says FT Markets Advisors' Tchir. "Dealers wouldn't have the luxury of saying to the ETF issuer, 'I don't want to buy these bonds' ."

Bond ETFs have undoubtedly been a huge success and may even have transformed the corporate bond markets, in the recent words of iShares. But it's debatable whether they've done anything to improve the market's deteriorating underlying liquidity, or whether they've merely shifted trading activity into a small subset of index names.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: Investing , ETFs
Referenced Symbols: CHK , HYG , JNK

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