Latest Banking Crisis Highlights ETFs’ ‘Additive Liquidity’

Report finds that ETFs provide ‘additive liquidity’ to what’s already available in the primary market, even in times of crisis.

On Monday, State Street published a report by SPDR Americas Head of Research Matthew Bartolini that discusses how exchange-traded funds can create additive liquidity to a market in times of crisis, meaning essentially that ETFs provide yet another way to access their underlying markets beyond investing directly in the underlying securities themselves.  

Right now, we’re watching just such a crisis unfold in the banking industry, largely sparked by the meltdown of Silicon Valley Bank earlier this month. The situation has been exacerbated by the breakdown of Credit Suisse—a long-troubled but systemically significant bank—over the weekend, such that the Swiss government had to step in and arrange for it to be acquired by UBS, another Swiss bank. 

Underlying Market Largely Unaffected 

Bartolini’s note mentions that while normally for every $8.50 in financial sector ETFs traded in the secondary market, only $1 led to a fund flow within the ETF itself. That ratio increased to $15 during the period of March 8-16, suggesting that the ETFs themselves are not having a major effect on their underlying securities, and even less so in times of market turmoil.  

The note says that the trading in financial sector stocks that was expected to be associated with ETF-related actions in the primary market was 1.7% during the March 14-16 period, and was never greater than 4% even when flows surpassed $1 billion. 

Indeed, trading volumes spiked to $13 billion on one trading day, a level that the report notes has not been seen since the great financial crisis, which saw levels as high as $30 billion.  

“The underlying securities were somewhat shielded from the uptick in volume, and the portfolio itself did not need to have as much trading take place,” he told etf.com in an interview. “That's the additive liquidity that ETFs provide over the primary market and can be a benefit during times of stress like this, because the underlying portfolio is not as impacted.”  

When it comes to passive investing in particular, there have been allegations that index investing can cause market distortions. However, no consensus conclusions have been reached, and the SSGA data lends further support to that not being the case, at least with ETFs. 

“ETFs can put the criticism [to rest regarding] pushing prices around or having market dominance, and it's because of this additive liquidity. Many investors were able to meet on an exchange to the price of a basket of banking stocks—and in some cases, some of those firms weren’t trading—agree to what that price would be and transact those shares, and it didn't have an impact on the underlying portfolio or the underlying stocks,” Bartolini said. 

“There's not a huge concern about market impact, but ‘not a huge concern’ is not the same thing as zero concern,” said Elisabeth Kashner, FactSet’s director of ETF research and analytics, noting that State Street is very good at maintaining liquidity in their ETFs.  

She notes that the $3.2 billion SPDR S&P Regional Banking ETF (KRE) was at pennywide spreads, but that with the size of its handle, that translates into 2 basis points of coasts borne by investors. Kashner also points out that the numbers can vary greatly among ETFs. "It's important to understand all of the components of the trading cost, from the spread to the market impact, and the spread is sometimes a function of volume,” she added, noting that not all ETFs are equally easy to create and redeem, and that liquidity is just one of many criteria to consider when evaluating an ETF.

Strong Options Volume 

Bartolini was particularly struck by the options trading associated with financial sector ETFs, which he described to etf.com as “record level.” Even more interesting is the fact that a lot of the activity was “call side action.”  

“With markets cratering like this, you're thinking about hedging and downside risk, but the fact that there is significant call side action in conjunction with significant inflows, particularly on one of the bigger up days, [it suggests] that there's a lot of reactionary ‘buy the dip’ type of positioning for bank stock ETFs. I just think that’s really interesting, because typically when we see such large three-standard-deviation moves, you may even see a rush to the exits,” Bartolini told etf.com.  

“The day we saw the big inflows into [the $3.2 billion SPDR S&P Regional Banking ETF (KRE)]—the billion-dollar, record-setting inflows—was on the day bank stocks were up [around] 4%,” he added, noting that the options trading creates another use case for ETFs, one that is more sophisticated than simply buying and holding them as part of a strategic asset allocation. The report indicates the put/call ratio fell below 1 on March 16 in particular, with calls outnumbering puts.  

Bartolini says that the options trading is a big deal. “It's a great case study of sort of the ETF ecosystem, how investors are using it, how it behaves during crisis and the type of use cases that are a result of that,” he said.  

The report concluded that “greater use of ETFs — whether long, short, or derivative-related — rarely has an outsized impact on the underlying market,” and that SSGA expects this to remain the case during the current banking crisis.  

The efficiency and additive liquidity are testaments to the ETF ecosystem, Bartolini says, pointing out that State Street itself fair valued Signature and SVB at zero shortly after the news about those institutions became public.  

Contact Heather Bell at [email protected]