Tail Wagging the Dog? – Franklin Templeton comments on ETF market resilience

Feb 27th, 2019 | By | Category: ETF and Index News

ETF STRATEGY NEWS! ETF Strategy is delighted to announce the launch of ETF Strategy Hub (hub.etfstrategy.com), an on-demand repository of webcasts, videos, podcasts and white papers. Debuting with Special Series on Technology & Innovation in China and the Digital Economy.


By Jason Xavier, Head of EMEA ETF Capital Markets at Franklin Templeton Investments.

Jason Xavier, Head of EMEA ETF Capital Markets at Franklin Templeton Investments.

Jason Xavier, Head of EMEA ETF Capital Markets at Franklin Templeton Investments.

This article will address a question that we occasionally field: “How would the failure or departure from the market of [a market maker or authorized participant] affect ETF liquidity?” In doing so, we hope to add some context and correct a number of unfounded concerns.

Two themes that we occasionally encounter in meetings with clients are:

– Concerns that ETFs will cause the next downturn; or that ETFs create and exacerbate volatility.

– Questions about the risk of market participants failing, withdrawing or stepping away from the market under stressed market conditions.

Before we delve into these issues in detail, it’s worth reminding ourselves that the global ETF market represents approximately 10% of the global open-ended fund universe. While we have seen exponential growth in global ETF assets over recent years, the sector is still very much a junior sibling to the significantly larger mutual fund universe.

Appreciating this relative position should help put in context the accusation that the influence of ETFs on the wider market is a case of “the tail wagging the dog”.

Do ETFs exacerbate volatility?

Volatility is a function of investor flows. Ultimately the decision to direct an investment resides with the end-investor.

The vehicle used to express this decision can vary: from participating in mutual funds or ETFs to buying/selling the underlying stocks or bonds directly. And investors will experience different levels of transparency, depending on their choice of vehicle. For example, executing a decision via a mutual fund will typically result in an end-of-day trade.

An investor using an ETF will have full transparency on pricing throughout the trading day, in effect gaining access to democratized price discovery and ultimately volatility.

The ETF’s intra-day flexibility has allowed end investors the same executable transparency that until now has only been the preserve of market participants for fund investments.

So, in our analysis, far from being a source of increased volatility, ETFs actually democratize volatility and allow investors to see how risk is changing throughout the day.

What happens if an ETF market participant withdraws or fails?

Authorized participants (AP) act as an intermediary between buyers and sellers of ETF shares. An AP has authority to trade in the primary market, facilitating creation and redemptions directly with the ETF issuer/asset manager.

Source: Franklin Templeton.

Source: Franklin Templeton.

Authorized participants are financial institutions, typically household banking and stockbroking organizations already fulfilling both primary and secondary market trading in all listed securities for mutual funds, ETFs and ultimately single stock/bond activity. So if we’re considering the implications for the ETF market of an authorized participant failing or withdrawing, we should also look at the other roles these organizations fulfill in the wider investment universe.

In all instances, these companies participate in the market because there is an economic benefit to incentivize involvement. There is no more obligation for an authorized participant to act as an intermediary in the trading of mutual funds or individual stocks than there is for ETFs.

Execution commission and arbitrage opportunities are often considered benefits for facilitating primary and secondary market transactions. Indeed, both execution commissions and arbitrage opportunities provide incentives for primary market ETF trades. As a result, the ETF ecosystem features a number of authorized participants. Most ETF managers employ a multiple authorized participant model, effectively diversifying their reliance on one intermediary.

Therefore, if one—or even more than one—participant should step away, others should remain to provide a solution ensuring market liquidity.

But what if there were to be a more systemic issue that meant there were no market participants to facilitate primary market trading in ETFs?

Given that most of these players also underpin the wider trading in stocks and bonds globally, their reluctance or inability to trade would likely have wider implications, not just for the 5% of the market made up by ETFs, but for the other 95% too.

That’s scarcely a case of the tail wagging the dog.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)

Tags: , , , , ,

Leave a Comment