SEC to ETFs: Who are your market-makers?

The Securities and Exchange Commission approved on October 13 a rule that includes a requirement for ETFs to report which banks are the most active middlemen in the $ 2.4 trillion market. The move reflects SEC officials’ concerns that they don’t know enough about how the withdrawal of a few major traders could disrupt ETF prices for everyday investors, according to people familiar with the matter.

“They are being very honest about it – they don’t understand how ETFs work and how they are impacted” by stressed markets, said John McGuire, a partner at Morgan, Lewis & Bockius whose clients include many ETF providers.

The disclosures, which are required starting in 2018, are among the first specific changes to emerge from the broad SEC review of ETF trading and complexity that has been conducted, off and on, since 2011, according to people familiar with the matter. Concerns have grown since then as more complex funds have been launched and ETFs have sometimes endured huge price swings.

Nose-diving prices for ETFs on August 24, 2015, triggered trade halts that made it harder for shares to rebound and caused some investors to lock in losses. The SEC is still examining the circumstances around August 24 and other bouts of market turmoil and plans in the next several weeks to issue an analysis of whether disruptive trading practices worsened volatility, the people said.

“August of 2015 was totally unexpected and the SEC doesn’t like to be taken by surprise,” McGuire said.

Investors have flocked to ETFs in recent years as a lower-cost alternative to mutual funds. Consultant PwC expects North American ETF assets will nearly triple, to $ 5.9 trillion, over the next five years.

ETF sponsors pushed back on the new disclosure mandate but didn’t succeed in convincing the SEC to do away with it.

“Increased transparency…may have detrimental impacts on the vibrant ETF market and individual shareholder investment,” fund sponsor Invesco Advisers Inc. wrote in a letter to the SEC earlier this year. Revealing which market makers play a big role in supporting ETFs “may discourage” market makers “from participating in the ETF market entirely,” Invesco wrote.

Several stock exchanges have already amended trading rules in response to the mayhem of August 24. The changes were designed to reduce the number of trade halts that ETFs experience and allow prices more room to vary during periods of market stress. The SEC issued a white paper exploring the causes of turmoil on that date, which it suggested could have stemmed from investors dumping ETF shares to quickly reduce their exposure to the US stock market.

Because ETF shares are traded on exchanges, with constant buying and selling, an ETF’s market price can veer from the fair value of its assets. When that happens, investors buying or selling ETFs can get shortchanged.

That is why regulators and fund sponsors rely on middlemen such as Goldman Sachs Group Inc. or Morgan Stanley to step in by supplying or removing ETF shares from the market, which forces prices back in line with the fund’s underlying assets.

The specialized market makers have a financial incentive to intervene. When ETF shares trade at a premium to the fund’s assets, brokers can earn nearly risk-free profits by purchasing the less expensive holdings and exchanging them for higher-priced ETF shares. They benefit by trading in the opposite direction when ETFs sell at a discount to the fund’s assets.

Some regulators, including SEC Commissioner Kara Stein, have pushed for ETFs to reveal whether the more than 1,750 ETFs may not have a sufficient number of middlemen, who are known as authorised participants, to ensure steady trading and fair pricing. “Do ETFs face a greater risk of market makers stepping back during times of extreme volatility?” Stein said in a speech this year.

Citigroup, one such ETF market maker, temporarily stopped redeeming some ETF shares in June 2013 amid a selloff in emerging market stocks. The bank said it suspended activity after selling fervour caused it to hit self-imposed risk limits.

BlackRock and others who offer ETFs say concerns about too few market makers performing the activity are overblown. If a broker supporting a major ETF were to stop supporting the fund, BlackRock says, another would surely takes its place.

This article was available on Pro Financial Regulation first, before being published to Separate subscription required for Pro Financial Regulation; more information here.

Write to Dave Michaels at

Chris Dieterich contributed to this article, which was published by The Wall Street Journal

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