The Federal Reserve is raising concerns over liquidity in parts of the financial markets, but ETF market makers aren’t worried that tightening conditions will affect their operations.
The central bank’s latest financial stability report noted a drop in quote depth for interdealer Treasurys, S&P 500 futures and oil futures contracts since late 2021 due to questions over the Fed’s rate-hiking plans and uncertainty in the wake of Russia’s invasion of Ukraine.
While the report said there are no signs of severe market malfunctions, and effects on trading costs for investors are limited, it raises concerns that declining market depth could spiral into a negative feedback loop of volatility.
Such liquidity concerns are inherent as the Fed moves to tighten monetary policy. However, it’s not clear how much a tightening in liquidity in those sections of the market would affect ETFs, which have kept trading through intense volatility like the COVID crash of March 2020.
“With ETF volume adding a different layer of liquidity to the underlying securities and market makers’ ability to hedge in a variety of ways, we think ETF liquidity will stay steady,” said Charles Ragauss, head of trading at Toroso Asset Management.
While the Fed is showing concern over liquidity and pricing for large block trades of assets, Reggie Browne, principal at market maker GTS, said the recent volatility isn’t making him worry about the creation/redemption mechanism failing to work as advertised.
“If you compare it to March 2020 when there was marketwide systemic risk in the marketplace, this is just a price reset based on inflation, higher interest rates, and where folks are thinking about pricing and risk in real time,” he said.