In an attempt to address the rising liquidity concerns for bond-related exchange traded funds, the Securities and Exchange Commission is working on rule changes to the creation and redemption process.
The SEC could soon permit all bond ETF sponsors to use similar debt securities when creating ETF shares made up of difficult-to-find or less liquid securities, Reuters reports.
Currently, the SEC requires underlying securities used to create most ETF shares to be the same securities as in the ETF’s underlying portfolio unless the benchmark has changed. However, the SEC could revise its rules, allowing providers to substitute difficult-to-find securities with a similar bond to create ETF shares.
BlackRock, Vanguard and a few other large providers have been given greater latitude to create shares through similar securities. The greater flexibility has helped the group of bond ETF providers grow assets by reducing costs and making it easier to operate. Consequently, the rule changes could also help level the playing field for newer and smaller bond providers, like Northern Trust, Van Eck Global and Charles Schwab.
“Regulation should not create an uneven playing field that disadvantages certain shareholders,” Marie Chandoha, president and CEO of Charles Schwab Investment Management, said in the Reuters article. “We believe strongly that steps should be taken to ensure that ETF investors benefit equally.”
ETFs undergo a creation and redemption process in which market makers, authorized participants or large institutional investors swap a basket of securities from the underlying benchmark index for ETF shares, or vice versa.
The creation and redemption process helps keep an ETF trading near its NAV and allows large traders to go in and out of what appears to be an ETF with low liquidity. For instance, if an advisor or investor is interested in taking a large order on an ETF that only trades on a couple thousand shares per day, he or she would contact a broker or authorized participant. Behind the scenes, the AP would tap into the underlying benchmark to acquire the necessary liquidity to back the large ETF trade. [How ETFs Are Traded]
The potential changes to the creation and redemption rules would also help address growing liquidity concerns about the underlying bond markets. As banks and institutions hoard fixed-income securities, investors have turned to bond ETFs in response to the lack of liquidity across the underlying markets, potentially setting the stage for liquidity problems if ETFs experience large redemptions during a major sell-off. [Liquidity Concerns in Corporate Bond ETFs]
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.