With the growing importance of exchange-traded index funds (ETF), warnings of their risks have increased in the past. But these may have been overdrawn. Because when the capital markets went to their knees in February and March due to the rapidly spreading corona pandemic, not only did the market infrastructure hold up as a whole, but ETF trading also functioned quite smoothly. Enrico Bruni, Head of Europe and Asia at the trading platform Tradeweb, explains in an interview why investors were even more strongly interested in the bond ETF, which had previously been viewed as critical, during the crash.
“We are a listed operator of online marketplaces for financial products,” he describes the company’s activities. It must be said, however, that Tradeweb is a fully regulated trading venue and plays on an equal footing with traditional exchanges such as the London Stock Exchange (LSE) or the German Stock Exchange. In April, the daily average of $ 791.7 billion was generated on Tradeweb’s platforms, an increase of 7.2 percent over the same month last year. Still, things have calmed down a bit, with the average daily trading volume in stocks, ETFs, bonds, derivatives and money market products still at a good $ 1 trillion a day in March. That was around a third more than the average for 2019.
“This is not a financial crisis, but a public health crisis”
There has been controversy about the risks of passive investment products, which are increasingly popular with institutional and private investors. Those who warn of risks are particularly concerned with the topic of liquidity: the reason why an ETF cannot be more liquid than the assets it depicts – i.e. shares or bonds. This applies in particular to corporate bonds or riskier bond products such as high-yield bonds. Only a small proportion of them are traded on regulated exchanges and instead take place bilaterally between banks and brokers. But if only small portions of a bond are traded on the stock exchange, a price drop could result if an ETF is sold on a large scale.
But when the markets crashed in March, Bruni said there were no serious problems in ETF trading. “It is very clear that the market infrastructure worked reliably and consistently during the period of extreme uncertainty,” says Bruni. “This is not a financial crisis, but a public health crisis.” The expectations of the stricter regulation of trading venues – in Europe through the Mifid II rules – have proven their worth. “The markets remained transparent and investors protected, which is important in times of stress.”
Strongly increased sales volume
However, the crash was already noticeable – on the so-called spreads. They indicate the difference between willingness to buy (“money” or “bid”) and willingness to sell (“letter” or “ask”). The greater the difference – in market jargon: the wider the spread – the more illiquid a financial product is typically. “ETF spreads widened in March,” Bruni reports. “But this was consistent with the widening of spreads for bond products, the same applies to equities.” In addition, all data – Tradeweb observes the time it takes to process a trade – before the intervention of the central banks indicated “a liquidity bottleneck in corporate bonds”.
Overall, like other stock exchange operators, Tradeweb also saw a strongly increased volume of sales at the height of the crisis. Bruni speaks of a “substantial increase”, which calmed down somewhat in April and May. However, ETF trading remained at a high level. In the first quarter, daily average ETF sales in the US and European stocks were $ 9.2 billion, more than double the previous year’s quarter. Volumes were lower in May, but at $ 3.8 billion (US) and $ 1.6 billion (Europe), they were still 60.6 or 5.1 percent above the same month last year.
Run on bond ETFs
“We saw substantial growth in ETF trading,” Bruni reports. “In relative terms, there was the larger increase in bond ETFs.” According to Bruni, 46 percent of ETF trading in April was in bond products, under normal circumstances it would have been only 30 to 35 percent. It looked similar in May.
In the crisis, precisely those products that had been expected to pose the greatest problems, namely the bond ETF, gained in importance. “At the height of the crisis, investors wanted to express their views on certain macro issues or to secure themselves,” says Bruni. A flight of investors in US government bonds was observed in March. Apparently, many of them use ETF for this. In April, the volume declined somewhat, but the relative overweight of bond ETFs persisted.
However, trading in individual bonds also increased significantly in April. The average daily trading volume in US government bonds climbed 16.7 percent year-on-year to $ 89 billion on the Tradeweb platform. Trading in European government bonds even rose 23.5 percent to $ 27.3 billion. “We saw increased activity in March and April,” says Bruni. “The markets for government bonds in the developed countries were strongly influenced by the activities of the central banks in March and then by the increased issuing activity of the states in April.”
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