State Street Inverts The ETF Plumbing

December 15, 2016

I’ll admit, in most cases, the last thing in the world you want is your plumbing to run backward, but today’s press release on a new way for authorized participants in fixed-income ETFs kind of does exactly that.

Fair warning—this is some nerdy stuff, but I think it’s pretty cool.

How It Usually Works

Imagine you’re the portfolio manager for the SPDR Bloomberg Barclays Agg ETF (BNDS). Your portfolio holds 3,248 bonds at last count. Each day, you have to figure out what new bonds you actually want if an authorized participant shows up with an order for 100,000 new shares (worth about $5.6 million).

You certainly aren’t going to ask the AP to buy miniscule lots of 3,248 bonds, so instead you come up with a basket that broadly represents the exposure you need to keep the characteristics of the fund intact. As I write this, that’s still a huge list: 1,744 individual bonds, and then $436,1060 in cash that State Street will use to round out what the AP won’t deliver.

That list of 1,744 bonds goes out to all the APs first thing in the morning and they monitor that basket, knowing they can use it to make new shares. They’ll do their job, looking for a price discrepancy between how much the basket will cost them to buy, and how much the ETF is actually trading at.

Any time it looks like they could simultaneously buy all the bonds and sell the ETF shares for a profit, bingo, they pull the trigger. State Street and Bloomberg created a slick, mostly automated way of doing all this back in 2014 called “BSKT.”

The Problem

But trading bonds is hard. Now imagine there’s an AP with a small bond desk, and the AP looks at that list, and there’s some piece they just don’t think they can get easily, say, the 971 bonds from Consumers Energy in today’s basket. But the AP happens to have a whole pile of Southwestern Energy Bonds, which is also in the index, but isn’t on the list.

So, the AP calls you and says, “Hey, Bob, can you take this instead of what you asked for?” and a negotiation happens. In the end, you might say yes, or you might say, “You can send me more cash and I’ll just go buy them myself.” It works, but it’s a big, human, sloppy negotiation that both slows down the process and is rife with information gaps.


A New Solution

What State Street and Bloomberg launched today is an enhancement to BSKT that changes the process. Now the AP can load their inventory into their terminal, including all the bonds they’d be happy to use for creating more shares of BNDS. SSgA of course will also load up the basket it ideally wants today.

But now, both SSgA and the AP can see what’s on offer. That means that the negotiation about “what’s an acceptable basket” becomes substantially more streamlined. That, theoretically, makes pricing the ETF close to fair value even more efficient than it already is.

Does It Matter?

There are a few interesting wrinkles here. First, it actually creates a bit of a new kind of trading infrastructure around bonds, with potentially dozens of different counterparties all posting their inventory into BSKT, which is a bit like a prospective crossing network.

Instead of big bond desks taking capital risk by buying and selling bonds from inventory, APs and ETF issuers become the de facto inventory, responding to external price dynamics as rendered in the price of ETFs. That’s kind of cool.

I do wonder about whether this deepens the haves and have-nots in the ETF industry. The SEC has taken the position with most new ETF issuer’s exemptive relief that creation baskets must be the same for all APs, and must represent a pro rata slice of the fund, with some exceptions for liquidity and optimization.

Yet other issuers with older exemptive relief can customize their creation baskets however they like, which some have argued creates an unlevel playing field. This new twist on the ETF plumbing is likely to help the old guard more than the newcomers.

At the time of writing, the author held no positions in the security mentioned. Contact Dave Nadig at [email protected].


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