Let Me Read You a Bedtime Story

‘Twas the morning of payrolls, a time to switch off the screens and settle into a comfy chair with a warm mug of tea. Your mind has been full of trade wars and technical laws; the noise of markets as deafening as it has been uncomfortably inexplicable. It’s not just in your mind. The year so far has been resoundingly loud, with the S&P500 experiencing as many days up or down 1% in the first quarter as it did two years ago. That was when the year kicked off with stock markets suffering a bloodbath on ‘China news‘.

You embrace the pause. The chance to breathe. You knew last year’s compression in volatility and overvaluation in many risky assets was unsustainable. You wanted to get back to some kind of normal. But this doesn’t feel normal, does it?

Beads of sweat appear on your brow. Your gut tightens. Ghostly images of the VIX on February 5th break into your mind. The dream return of volatility has turned into an inexplicable nightmare. The lion has awoken, it’s broken out of the cage, and you don’t know why or what it will do next.

Shhh, don’t worry… BlondeMoney is here to mop your brow, make your tea, and explain everything. Close your eyes, take a deep breath, and come with me into the world of…. ETFs.

You know what they are – they simply track the return of an index, and they’re tradeable at all times. No wonder 5 trillion dollars currently sits inside them. You’re impatient with this story already. You know this stuff. It’s mostly not leveraged and it mostly holds the underlying securities, so who cares, right? Stop troubling me with this…

I’m sorry Dave, I can’t do that. We need to dig deeper.

The genius of an ETF is its liquidity transformation. Want to track an index of something that barely trades, but with a product that’s always tradeable? Boom – here comes the ETF. It does this because of the arbitrage available to its market makers, known as Authorised Participants (APs). The story goes that they will always take the risk-free arbitrage opportunity if an ETF deviates too far from its intrinsic value (IV). If the ETF trades at a premium to its IV, the AP will sell the ETF and buy the underlying assets it tracks (or vice versa), then repeat until the arbitrage disappears. A natural balancing act.

You’re almost falling asleep now, this is so obvious… 

But what if the APs don’t do that at all? What if they’re massive prop desks, who use the liquidity from ETF trading to get them in and out of their chosen positions? What if they hedge their ETF positions in the most liquid and most correlated asset they can get their hands on, rather than the actual underlying? What if, in a remarkable twist, they hedge their ETF position by going out and shorting the specific ETF they’ve just been given?

Wait… what?

OK, let’s go back a step. Start with the simple stuff.

We can all understand that if a market-maker is paid for an S&P500 index tracker, they are now exposed to the performance of that index. We can understand it’s very unlikely that the cheapest and quickest hedge would be to go out and buy all 500 stocks in their index weighting. We can understand they would instead just turn to the S&P500 futures market. It’s massive, with average daily volume in the most liquid e-mini market over $140bn. But what if APs turn to this market for all ETFs, rather than just the specific ones tracking this index? Not to hedge all of their risk, but to hedge some of it. After all, most equity based indices have a high correlation to the S&P500.

Now let’s look at those numbers again. The biggest ETF out there is the SPY, and its average daily volume is $31bn alone. Not all of it needs to be directly hedged but that’s almost 20% of the entire S&P500 futures market daily volume, just for this one ETF.

That doesn’t sound too scary. Markets are full of big numbers. That’s global finance.  

No, the scary factor comes from what the APs actually do with all those other 5,000 ETFs out there. Blondemoney has been talking to them on your behalf, and with some difficulty. Did you know that the AP isn’t listed in the ETF prospectus? Did you know that they’re not always obliged to make a market? Do you know how many APs actually provide the markets in each ETF?


Don’t be embarrassed. This information isn’t clearly available. Isn’t that worrying?

Maybe. But the grand-daddy of ETFs, the man who founded Vanguard, Mr. Jack Bogle, he says this current volatility is nothing to do with them. He says Active guys hold similar stocks to the Passive guys. 

Ah yes, Jack gave a fascinating interview to CNBC on this yesterday. His most revealing comment was that ‘what we’ve seen in the market is lots of selling of Facebook shares, not lots of selling by ETFs‘. He’s right that it’s not as simple as “retail investor sells a FANG ETF, Facebook share price falls”. And he is right that the market is simply selling a lot of Facebook shares. But he is wrong not to associate the two points with one another.

If the ETF is sold, the AP has to adjust its inventory accordingly. And if Facebook is then part of the weighting of another, smaller ETF, then the AP has to adjust its inventory further for that ETF. And if the AP decided to hedge a lot of its FANG ETF market-making by warehousing a lot of Facebook stock, because, hey, everyone wants to own FANGs and they’re always going up, so let’s get limit long of them, then they might also have to adjust its inventory further as Facebook’s price falls.

And if Facebook is, say, a mega cap stock that features in other bigger ETFs, like the 8th biggest ETF in the world, the Nasdaq-tracking QQQ, then the 5% weighting of Facebook in that ETF forces inventory reduction for APs tracking the QQQ also. And if selling of the Nasdaq brings down other US stock indexes in sympathy, then selling of S&P500 futures will take place as people trade out of the 31bn dollar-a-day SPY ETF. And the AP might short the SPY itself to cover its position. And so on.

Yes, lots of people are selling Facebook shares Jack. And they may well be doing so for sensible fundamental reasons. But the vicious circle which links selling of Facebook to more selling of Facebook has been created by the role of APs in the provision of ETF liquidity.

That wasn’t a very nice story. 

BlondeMoney is sorry. Take the break now while you can. Worry about payrolls if you like. But the market structure right now is so incredibly fragile that there are much bigger worries ahead. At its peak, the CDO market was $2 trillion, approximately one-fifth of the size of the S&P500 market cap. ETFs, at 5 trillion right now, are equivalent to one-quarter of current S&P market cap.

Thanks. I need something stronger than tea now.

Sure, I’ll whip up a whisky cocktail for you. And don’t worry, BlondeMoney is putting the finishing touches to a report that will explain all of this in much more detail. Want to read it? Click here if so…

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