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Besides the continuous growth of ETFs, the Flash Crash in 2010 triggered detailed investigations by regulators on how ETFs affect the financial market. This literature review provides a broad overview of recent academic studies analyzing the effect of ETFs on liquidity, price discovery, volatility, and comovement of the underlying securities. The rapid growth of ETFs, coupled with their potential to transmit and amplify risks to financial stability, warrants further evaluation of regulatory action, in particular from a system-wide perspective. At the same time, liquidity and counterparty risks in ETFs might have implications for the wider financial system under certain conditions.
Understanding the ETF Liquidity Ecosystem
Are collective trust funds established and maintained by JPMorgan Chase Bank, N.A. The funds are not required to file a prospectus or registration statement with the SEC, and accordingly, neither is available. The funds are available only to certain qualified retirement plans and governmental plans and is not offered to the general public. Units of the funds are not bank deposits and are not insured or guaranteed by any bank, government entity, the FDIC or any other type of deposit insurance. You should carefully consider the investment objectives, risk, charges, and expenses of the fund before investing. Securities that trade on large, well-known exchanges are more liquid than those trading on smaller exchanges, so ETFs that invest in those securities are also more liquid than those that don’t.
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The liquidity of active ETFs
First, the current regulatory frameworks could be enhanced by adding ETF-specific rules. For example, the UCITS Directive, EMIR or the SFT Regulation could be adjusted to account for the potential implications of counterparty risk in ETFs for financial stability. Second, given the specificities of ETFs a dedicated regulatory framework could be envisaged.
- Exchange traded funds (ETFs) provide access to a diversified portfolio of securities such as stocks or bonds.
- The underlying assets are traded and arbitraged by the authorized participants (large institutions), who it is hoped keep the price of the assets close to the net asset value.
- Australian bonds are favored over those of Singapore and German bonds are favored over those of Finland, all because those markets are larger.
- If you view yourself as a trader, then you may already be aware of this.
- In these instances, APs can profitably eliminate price discrepancies and provide further liquidity to the market by creating or redeeming ETF shares.
- Margin requirements for OTC derivatives, as well as transparency with respect to securities financing transactions (SFTs), further limit the potential effects of ETF counterparty risk on financial stability.
How easily the market maker can deliver or sell securities depends on the liquidity of individual securities in the ETF portfolio. ETFs are supposed to be very liquid because share owners can sell their shares at any time of the day, as long as there is a buyer for them. The share owners are unconstrained sellers because the price they sell at is not required to be the net asset value.
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Alternative investments involve greater risks than traditional investments and should not be deemed a complete investment program. They are not tax efficient and an investor should consult with his/her tax advisor prior to investing. Alternative investments have higher fees than traditional investments and they may also be highly leveraged and engage in speculative investment techniques, which can magnify the potential for investment loss or gain. The value of the investment may fall as well as rise and investors may get back less than they invested.
Large redemptions and negative feedback loops to the counterparty are two important channels through which counterparty risk may affect financial stability. First, similar to standard investment funds,[29] large redemptions as a response to increased counterparty risk would lead to forced selling of collateral securities by the ETF. For counterparties relying on ETFs as a source of funding, large redemptions may exacerbate the initial stress. Counterparties using the swap or ETF exposure itself as a hedge for their trading positions may be suddenly more exposed to the risks they were aiming to hedge.
What Affects an ETF’s Liquidity?
The trading volume of an ETF also has a minimal impact on its liquidity. ETFs that invest in stocks in the S&P 500, for instance, are frequently traded, which leads to slightly greater liquidity. Low-volume ETFs typically follow small-cap companies that are traded less often and, hence, less liquid. The size of an ETF affects its liquidity, with larger funds generally having more liquid shares.
