The ETF industry could have just been handed a 415-page game changer by the U.S. Securities and Exchange Commission. In response to ongoing concerns about the ability of ETFs to deliver their liquidity promise to investors, the SEC is now proposing rules to ensure providers can meet investor redemptions in the event of a panic—without completely blowing up the market in the process.
The proposed rules are meant to ensure market stability—after all, some ETF investors got an unwanted surprise on Aug. 24, when the market plunged leaving some ETF shares trading at huge discounts relative to their holdings. It was a short, sharp dip—and it was reversed relatively quickly. But for regulators, it’s a sign of possible risks. Read more here.
So what exactly is in the proposed rules?
Be grateful to Dave Nadig of etf.com who combed through the entire document and distilled the main takeaways in this post last week (Nadig calls it a liquidity bond for ETFs). The main idea with the rules is to nail down exactly what the liquidity risk is for a specific ETF (or mutual funds) and what kind of impact a mass liquidation would have on the broader market.
These are questions regulators have been asking for some time —the new rules aim to get at the answers. Here’s how:
Ensuring redemption demands
ETFs (and mutual funds) will need to come up with a plan to ensure they can meet the redemption demands from investors during times of market stress according to the new rules. Funds will have to classify and review all the assets in their portfolios based on how fast they can be converted into cash. Under the new rules, fund can’t have more than 15% of assets in securities that would take longer than seven days to liquidate.
ETFs (and mutual funds) would also have to analyze redemption patterns in relation to the fund’s portfolio to maintain a minimum percentage of assets that could be dumped within three days.
Nadig sees a few important consequences for ETFs:
Hard luck for big funds – Since the new rules are all about the ability to sell off all the assets in a portfolio, the biggest funds will have the hardest time doing this since they have more positions than smaller funds. Nadig says this increases the likelhood of big funds closing to new money (leading to premiums) or including off-index-weight positions in the portfolio (not ideal).
The rise of trade impact analysis – Estimating how long it would take to unload positions isn’t exactly easy especially when it you have to ensure it can do so without having any impact at all on the market. It actually sounds impossible. Nadig says that new portfolio analytics and trading partners will rise up the fill the gap. A model will have to take into account a myriad of competing factors like the existence of an active market for the asset, frequency of trades, volatility, bid-ask spreads, fixed income variables like maturity and issue date, trading restrictions, position size, and relationship to other assets in the portfolio. Big pension funds and insurers are already on this—it might be a good opportunity for ETF providers and fund managers to compare notes (and models).
Trouble for illiquid assets, junk bonds etc. – Assessing the impact of ETFs in the bond space will be tricky, particularly for junk bonds. Could it end up killing high yield bond ETFs? Probably not Nadig posits—he’s hoping the SEC backs off and makes exceptions for some single asset class ETFs in liquidity-challenged segments of the investment world.
If not, illiquid assets could disappear from the ETF world, heading for different kinds of fund structures that can handle the liquidity conundrum. Or funds could get around the issue using swaps—or ETNs?
Where to from here? There will be much volleying back and forth between ETF providers and the SEC before rules are finalized—so it’s not over yet.
But Canadian regulators will no doubt be looking closely at what the SEC does next and that could have far reaching consequences here as well not only for the ETF industry but for investors who’ve come to rely on them.
Also read: