Meanwhile, the steps taken by Citigroup and State Street are red herrings, the analysts said.
“Citi’s action was taken after a trading desk reached its risk allocation limit. While this revealed heightened trading demand amid anxious markets, it mostly reflects Citigroup’s specific capital limits and is not an ETF-industry or specific-ETF issue, per se,” according to Sanford Bernstein.
“State Street’s action was also more benign than at first glance. ETF sponsors like State Street generally redeem ‘in-kind’ by delivering shares to authorized participants that handle the ETF creation/redemption process. This mechanism increases ETF’s tax efficiency. As a service, sponsors will (at their discretion) offer cash redemption to dealers,” it added. “Doing so means the ETF sponsor will subsequently need to sell the underlying itself. When markets are moving in one direction, this can compromise tax efficiency and result in trading impact costs, to the detriment of remaining ETF shareholders. State Street sought to avoid these consequences. Also, we believe cash redemptions make up a small portion of total redemptions, further limiting State Street’s action as a meaningful sign of ETF market stress.”
The analysts point out that the Financial Times published a subsequent article, “ETF providers reject ‘stress’ reports,” that clarified a number of issues discussed in its initial story.
“The publication deserves credit for: 1) getting the scoop on these market developments; and 2) having the intellectual wherewithal to advance conversation about these developments in a constructive direction,” they wrote.
Going back to the overall bond ETF business, Sanford Bernstein said it now sees more long-term potential than previously estimated.
“Our change of heart is because we see how they can be additive to markets. Importantly, they could be part of the solution for a fixed income market that is struggling to maintain liquidity as large broker/dealers reduce risk, cut inventory positions, and husband liquidity and capital. Yet nothing would be as detrimental to ETF growth (fixed income or otherwise) than for one of these products to somehow spectacularly fail,” according to the note.
“We acknowledge some real operational risks are embedded in these products (securities lending and collateral practices come to mind) and that the unintended consequences of the growth of ETFs for overall market structure have yet to be fully discovered,” the analysts concluded. “But erstwhile, it is critical to distinguish known factual risks from merely perceived ones.”