BlondeMoney CEO and founder Helen Thomas has been interviewed by LiquidiTV about what she believes is the biggest vulnerability in the market.
Below is her interview, although should you want the PDF version you can find that by clicking here.
If you have any questions about the follow, please email us.
Normally we have our new segment ‘getting to know the industry’ here, but thanks to a fascinating markets conversation with a good friend (whom we met through our last hedge fund), we decided to hear her thoughts on the catalyst for an coming financial crisis i.e. ETFs.
Helen Thomas is one of our regular experts for our fortnightly question and is the Founder of BlondeMoney, a macroeconomic consultancy and research specialist company she launched in 2017. Having graduated from Oxford, she worked at Merrills in FX, was a partner at a Global Macro hedge fund and advised the Chancellor of the Exchequer George Osborne during that little financial crisis we had in 2007/2008. Currently she is a board member of the CFA, UK and a few years back was the lead researcher for the book “Masters of Nothing”.
What do you think the issue is with ETFs?
ETFs were a great idea. They combined the investment into a fund with the ability to trade it at any time on an exchange. Instead of buying 500 stocks in the S&P, you could buy the SPY ETF, which closely tracks the performance of all those stocks. Same returns, but cheaper and more efficient; what’s not to like? The reality is that they contain a design flaw. The tracking process comes about because market makers arbitrage away differences in price, between the underlying and the ETF. If they deviate, there should be a risk-free return because they’re the same thing, right? But, arbitrage only works when there is liquidity. And the liquidity in an ETF is dependant on the market makers and their creation agents, the APs (Authorised Participants). They aren’t obligated to make a price, and if it’s too hard to get hold of, say, a high yield bond, then they step away from pricing, say, the HYG ETF. It’s nothing to do with Blackrock or Vanguard; they’re just the shop front. If you go in to buy some chewing gum, it won’t be there if the suppliers stop delivering.
What alarms you about the current situation in the ETF market?
In 2007, CDOs equated to one-fifth of the market capitalisation of the S&P500. The ETF market, at 6 trillion, is now of a similar size. The ETF market is now just too unwieldy. The hedging process that allows the APs to provide ETFs means that their flows are dominating the market: they’re all the same way, all at the same time. The hedging is usually done automatically, so the orders hit the market in milliseconds of receiving the risk. The hedging process relies on correlation. Even Latin American equity ETFs, such as the ILF, have a 70% correlation with the S&P500. That means you can clear 70% of the risk immediately by trading an S&P500 future. Or, why not use the SPY ETF? Yes, ETFs are used to hedge ETFs.
Managing all of this risk are the Delta One trading desks of banks and brokers. They can make decisions on whether to hedge the remaining 30% of that ILF flow, for example. If they choose not to, they are taking prop risk. Banks are taking on hidden leverage on the back of ETF flows. Oh, and their capital charge is lower if the risk sits on the Delta One desk, because those positions are for ‘market making purposes’.
Hidden leverage and unpredictable liquidity are the hallmarks of every financial crisis we have ever seen.
How do you see markets unfolding down the track if things don’t change with ETFs?
So ETFs depend upon functional liquid markets. We are now at a turning point when central banks are turning off the Perma-QE taps. Liquidity, having been pumped in, is being sucked out. The virtuous circle where QE drove money into passive investments which compressed credit spreads, lowered volatility, and led money back into risky assets – that’s about to turn into a vicious one. We have already seen the tremors. The “Volmageddon” of February has set the process in motion. Volatility begets volatility as it feeds into risk models of long-term money managers as well as option delta hedgers. We are seeing drive-bys in market after market: Facebook, Russia, Argentina, Turkey, and now Italy. Everyone has to adjust their exposure to risk. Which changes the price of risky assets. Which is used to calculate risk. And so on.
There are no macro narratives now, only the unwind of an unstable market structure.