Timeline Of A Crisis

Batten down the hatches. Can you feel the storm coming? Did you hear the warning from the Cap’n? Andrew Bailey, Chief Executive of the Financial Conduct Authority couldn’t be clearer in his speech last week:

‘our job is to be watchful to the build-up of risks and vulnerabilities in the system… The secondary market liquidity of ETF shares is dependent on market makers and authorised participants… We know relatively little… about the capacity and willingness of APs to execute their function in stressed conditions where they may be under pressure to tighten their own risk limits. The result could be unexpectedly large discounts for ETF investors selling their holdings relative to the estimated value of the underlying assets, and possibly a need to suspend fund dealings… this could have the potential to amplify shocks to market conditions which are already under stress. We have no easy way of sizing this risk, but we cannot ignore its potential given the rapid growth of ETFs.…the global financial system is more resilient than it was… [the issue] lies in what level of continuous market liquidity conditions investors expect, and thus the liquidity transformation they accept.’ 

Aye there’s the rub. Liquidity.

This isn’t just a warning for a few years from now. It’s already happening. Prices are moving around more than we might expect under “normal” conditions.

Look at Facebook.

The weekly fall in its share price in March ranked as the third biggest weekly loss ever. It floated in May 2012, and suffered some big weekly moves around that time. But since then, fairly calm. Until this year.

You might argue that Facebook was overdue a correction; that tech companies are wildly overvalued; that the Cambridge Analytica issue was a canary in the coalmine for a company – nay, industry – now facing much greater regulation.

True. But are those arguments enough to warrant a weekly decline in the share price that sits in the top 3? The volumes traded that week weren’t even in the top 10. And what’s that coming in at no.11 in our list? The week including the VIX blow up. Is that a fundamental reason to sell Facebook?

Facebook constitutes a large part of many passive investments. According to ETFdb.com, Facebook is one of the Top 15 holdings of 106 different ETFs. Added up, their exposure to Facebook constitutes approx. $23bn. That constitutes 5% of its total market cap akin being a top 3 shareholder. (Click here to see our calcs).

Now, the holders of these ETFs might not move their positions all that much. But the market makers have to adjust their positions as the price moves. They are committed to tracking the underlying index. It’s like a shadow of the $23bn is just sitting there, having to trade each time Facebook’s share price moves.

If someone sells an ETF in the secondary market to one of the market-makers, then they have to lay off the risk as cheaply as possible. A computer is usually involved. It’s a simple algorithm. If Facebook is the biggest weight in the index, then cover that risk first.

The tracking mechanism of the ETF therefore creates a multiplicative effect. That’s why prices are moving more than we might otherwise expect, under “normal” circumstances. The amount of daily volume linked to passive investments is rising. As Credit Suisse noted, 40% of all trading volume now takes place in the first and last 30 minutes of the trading day, compared to 31.5% a decade ago.

With prices moving around more, liquidity is at a premium. That’s why we can get the 3rd worst weekly loss for Facebook taking place without the 3rd biggest weekly volume.

It’s only going to get worse. With fundamental investors confused, they sit on the sidelines. Delta hedgers are the only people who have to trade every day. With volatility levels rising, they trade in larger size on larger moves, in order to protect their position. Liquidity suffers further. It won’t take long before:

  • This impairs the ability for market makers to make money
  • They stop making prices
  • They’re kicked off the exchange
  • Liquidity in the ETF suffers
  • APs step in to create/redeem shares in the ETF itself, looking for an arbitrage profit
  • They ram all the orders into the close but liquidity is so bad from everyone trying to do the same trade at the same time that it’s executed at distressed pricing.
  • The arbitrage can’t be done. They step back from the market.
  • The ETF no longer functions as it should.
  • Investors are left holding an instrument that is entirely divorced from reality.

This process is now underway:

Step 1:  With more delta hedging taking place in larger size on larger moves, we will have prices move further than you might think for a number of days, then reverse track [Rusal dropped 50% the morning after sanctions were announced; rallied back 30% when they were thought to be eased two weeks later]
Step 2:  ETF issuers have to retire any products which struggle to track the underlying. [Barclays retired $1.2bn of ETNs on 12th April as they were no longer profitable, and reissued some with a new embedded call option]
Step 3:  Exchanges tighten up the rules on market-makers. [NYSE Arca issued new listing standards for ETPS in January]
Step 4:  Big winners will turn into the biggest losers as momentum reverses. Watch out for those much-mocked 200 day moving averages and other technical indicators that a market divorced from fundamentals relies upon
Step 5:  A squeeze on markets where the liquidity transformation is most out of whack. Credit markets, particularly high yield, should suffer.
Step 6:  Banks and brokers who can least manage the market-making and AP process to suffer losses.
Step 7:  ETF issuers to lose assets.

For now, in Step 1, fade the big moves. When we get to Step 4, the bigger breakouts will begin, and momentum will have turned.

At each stage, expect the narrative to change, isolating the issue. Credit ETFs were always a risk, they’ll say. Momentum stocks were overvalued, they’ll say. It’s Trump. Trade. Russia. Brexit. The Fed.

Yes, the fundamentals might understandably cause a re-pricing. But the mechanics of this market have created the perfect set up for it to turn into a crash.


Richard Thomas

For a start I think you should be using value traded not volume. This would certainly put the 23/03/18 week closer to the top. Secondly this would then put the FB in ETF 23bn into proper perspective. The value traded in the week of 23/03 was USD 75bn. Even assuming a 20% turnover in every one of the ETFs holding FB it wld only represent approximately 7% of volume.

I am not disputing the fact that ETFs are an additional level of possible supply in a sell-off and that the authorised participants and market makers have no incentive to maintain liquidity. However people need to have some idea of what is underlying – for example, HYG has a mkt cap of USD 15bn and its biggest current holding is SFRFP 7.375 2026 at 0.597% = 89mm. Even if 25% of HYG was for sale (unlikely) this would only require a bid for 22mm – it is a 5bn plus issue so that would be no problem.


Thanks Richard, I like the value traded suggestion. And good to put numbers on it, particularly HYG.

My concern is that it’s not the holdings per se which are the issue, but the hedging by market makers alongside it. Of the 23bn, each percentage move in the underlying FB shares means the market makers have to adjust the risk to continue tracking the price.

It’s like an option with a 23bn notional value. The delta has to be hedged incrementally so the value traded can be a significant chunk of the 23bn when it’s aggregated up over a week


Leave a Reply

Your email address will not be published. Required fields are marked *