As the Federal Reserve looks to interest rate normalization, some bond observers are worried about exchange traded fund liquidity risks in the event of a major sell-off. Consequently, the Securities and Exchange Commission has proposed a set of rules to help obviate the potential risks.
The SEC is concerned that funds might be exposed to debt securities that are not easily liquidated in the primary markets, reports Ari I. Weinberg for the Wall Street Journal. Specifically, the regulatory body believes some funds may be forced to sell illiquid securities in a fire-sale event that would drag down their price, which would cause a fund to incur heavy losses and lower its value.
Consequently, the SEC is proposing new rules to mitigate the risks. For instance, a proposed rule would require funds to categorize the liquidity risk of their holdings according to the number of days it would take to dump the assets without adversely affecting the market price. Moreover, regulators want to clarify guidelines that no more than 15% of a fund’s assets should be held in securities that would require over seven days to convert to cash.
However, financial industry groups, including the Investment Company Institute and several ETF issuers, argue that the proposals are not relevant to ETFs since the funds are not structured like traditional open-end mutual funds.
ETFs are traded on the stock exchange like common stocks, so shares are traded among investors, not between investors and the fund. As long as there is an investor willing to buy an ETF sell order, ETF shares are traded between investors, so no shares are being redeemed by the fund. ETF shares are created or redeemed by buying or selling underlying assets through an Authorized Participant when the ETF’s market price deviates from the net asset value of the underlying holdings. [How ETFs Are Traded]
On the other hand, mutual fund investors buy and sell shares from or to the fund. Consequently, mutual funds regularly sell underlying assets on the open market to pay for redemptions.
Since ETFs are traded between investors on a stock exchange, ETF issuers argue that the process helps insulate ETF investors from risks of a traditional fund having to dump illiquid securities on the primary market. [Reviewing the Liquidity of Junk Bond ETFs]
Nevertheless, the SEC and critics are worried that the Authorized Participant may not be willing to step into hard-to-sell assets in the event of a redemption, which would cause an ETF’s price to diverge from its net asset value or widening bid-ask spread on trades. The concerns have been heightened in recent years due to the post-financial-crisis environment – financial institutions are subject to increased regulation on risk exposure, with investment banks now holding 80% less corporate bond inventory than a decade ago, which has removed a significant player that traditionally helped add to market liquidity.
Max Chen contributed to this article.