ETF liquidity after the Japan and Middle East crises

Emma Cusworth looks at how liquidity has been impacted by recent crises in Japan and the Middle East

As the life-blood of ETFs, liquidity is vital. While robust trading volumes show a sanguine outlook for ETF liquidity, unforeseen market pressures in the future could put this to the test.

Indeed, average monthly volumes of ETFs traded on Xetra, Europe’s first trading venue in Germany, have seen spectacular growth since 2000, reaching over $21bn so far this year. Assets under management on the platform grew nearly 30% in the year to the end of February 2011, reaching $116.2bn, according to Blackrock.
This paints a very positive picture for ETFs, whose tradability is also ultimately ensured by their structure and regulation.

“Liquidity is the biggest phantom issue in the ETF market,” said Michael John Lytle, managing director at Source. “ETFs are governed the same way as other funds and all have daily liquidity in the primary market and intraday liquidity on the secondary market. Even during crisis periods they have proved to be as liquid as any fund from a primary perspective.”

Market forces
Nothing tests how theory translates into practice better than a period of severe market stress. Recent events, including the Japan tsunami and uprisings in the Middle East and North Africa have highlighted both the limitations and vast potential of ETF liquidity.

After the tsunami hit Japan, Société Générale, the only official market maker for Lyxor’s Japan (Topix) ETF, failed to post bid/offer prices for significant chunks of time during Monday 14 and Tuesday 15 March. When prices were quoted, spreads had dramatically widened, reaching over 700 basis points, up to 50 times the amount seen on Thursday 10 March. Normal market making was then resumed by Wednesday 16 March.

However, only the London listing for this ETF was affected. All other listings traded actively, reflecting the issue of fragmented liquidity in the European ETF market.
“A key lesson from the Japanese tsunami, and also the flash crash, is that market makers are a critical cog in the wheel of the ETF machinery”, said Ben Johnson, Morningstar’s director of European ETF research.

“When there is uncertainty in the markets bid/offer spreads on the underlying shares widen, which ultimately manifests itself in ETF shares. This is more pronounced in instances like we saw for Lyxor’s ETF because there was a single market maker who was essentially asleep at the wheel during that period of time.