The Risks of Not Using a Liquidity Provider – A Case Study

This blog post is relevant to institutional investors interested in trading exchange-traded funds (ETFs) in significant volume. Individual investors do not always have access to liquidity providers to trade ETFs as referenced below.

What if I told you that a large $500 million order and a smaller $1.2 million order traded in the same ETF, but one executed around the bid/ask spread and the other drove up the ETF price 84 cents, or almost 5%. Could you guess which trade was responsible for each outcome? The answer may surprise you. The $500 million notional block traded in-line, and a small order of $1.2 million notional block pushed the WisdomTree Brazilian Real Fund (BZF) price 5% away from its underlying value. The trades were done on different days and times, but the price of the ETF and its trading characteristics were similar. So what was the difference between the two trades?

On October 9, 2013, a 27-million-share block order worth approximately $500 million executed inside the bid/ask spread of BZF. You can see the trade in the highlighted area in figure 1.

Figure 1

The client who initiated that trade was able to work with an ETF liquidity provider who had the ability to access the underlying basket in the primary market on behalf of the client. It is important to remember that an ETF is at least as liquid as its underlying securities, regardless of the average daily volume. That demonstrates the beauty of the open-ended ETF structure and its ability to create new shares and redeem shares daily. This trade was successful from an execution standpoint because the client worked together with their trading partners on a best execution strategy.

On the other side of the execution spectrum, another investor entered a 70,000-share ($1.2 million notional value) market order in BZF on November 13, 2014, just before 3:39 p.m. ET. This resulted in a quick spike up in the price of the ETF, as you can see in figure 2.

Figure 2

In this second example, the order book, or depth of the bids and offers of the ETF trading on the exchange, handled a market order of this size in an inefficient manner. The depth of bids and offers in an ETF order book is not always reflective of the liquidity of the underlying asset. While there is a lot of liquidity in Brazilian Real forwards, there are not a lot of resting orders in the BZF order book. By definition, a “market order” is designed to buy or sell an investment immediately at the best available price on the secondary market and will not stop until completed. For this reason, the order for 70,000 shares swept up all available shares for sale until it was completed, which resulted in the price increasing by almost 5%. This was followed by the price of the ETF correcting back in line with the “indicative value” of the underlying basket. Figure 3, and the yellow arrow, illustrate how quickly the order was filled and how far the price moved to satisfy the 70,000- share buy order in the order book.