China Renmin University Business School EMBAEE Special Course Tutor

Guanghua School of Management, Peking University, supervisor of EE special course.

Chief economist of mushroom digital technology

Distinguished Professor of Business Psychology, Harvard University

Honorary Dean of Mushroom College

In March 2020, the stock market plunged like a storm, and ETF experienced an unprecedented test, without repeating the same mistakes, such as the crisis of 1987 "Black Monday" trading system and trading procedure collapse. This is largely due to the behind-the-scenes market-making transaction of ETF and the programmed arbitrage mechanism assisted by algorithm, which maintains and supports the dynamic balance between ETF and the underlying asset market represented by ETF, and ensures the rationality of ETF pricing mechanism, price discovery function and vital transaction liquidity. ?

On September 20 19, the SEC of the us securities and exchange commission announced the new rules of ETF trading mechanism for the first time, which took effect on February 23, 20 19 and was officially put into use. This regulation aims to lower the threshold for entering the ETF industry, encourage and stimulate competition among more ETF traders, and promote the diversification of the entire ETF market. The most striking point of this new ETF regulation is how to define and use the "customized basket" to create the subscription and redemption operation of ETF industry.

What is an ETF custom basket?

The original purpose of ETF is to better track the index and push the trading of index funds to a new dimension of transparency, efficiency, compliance and security. In order to manage this index tracking more accurately, ETF draws lessons from the successful experience of NASDAQ exchange and introduces market makers (called authorized participants or AP), who rely on the arbitrage mechanism between ETF trading market and ETF basic asset market to adjust and control the supply-demand relationship and deviation degree of ETF basic component prices relative to the tracked index. If the price of ETF trades at a premium or discount relative to its basic constituent stocks, ETF market makers will start their powerful algorithmic trading program and use this mispricing relationship to arbitrage, so as to bring the relationship between the two back to the right track and maintain the rationality of market pricing. ?

When the transaction price of ETF is higher than the so-called indicative net asset value iNAV, market makers will have the incentive to buy the constituent stocks that make up the ETF subscription basket, so that they can get ETF units in exchange. Then, they sell these products in the ETF trading market at an ETF theoretical price higher than the basic market price to obtain the intermediate price difference. ?

This activity is called ETF creation, because it expands the total holdings of ETFs and the number of shares in circulation. ?

When the ETF transaction price is lower than iNAV, market makers will have the opposite arbitrage motivation. They deliver the ETF to the ETF issuer, exchange the constituent stocks in the ETF basket at a low price, and then sell these stocks in the market at a normal price to make a profit and lock in the spread. ?

This trading activity is called ETF redemption, which reduces the total holdings and tradable shares of ETFs.

From the perspective of risk management, it is completely correct to faithfully copy the index weights in the ETF basket. However, in the actual trading operation, this seemingly unremarkable ETF market-making process is always dragged down by various problems in some transactions, which leads to the failure to create and redeem ETFs normally, thus hindering the tracking and trading of ETFs. ?

In the actual trading process, a huge challenge is the availability difference of basic constituent stocks in the index tracked by ETF, and the difficulty of trading operation to meet the regulatory requirements and generate a perfectly matched index basket in order to buy ETF in a short time. ?

This has led many ETF investment managers to allow market makers to deliver their own customized basket of underlying basic assets, which has brought great convenience to ETF market makers. Moreover, in some special cases, it is even allowed to replace hard-to-find stocks or bonds with cash or other collateral. Some investors worry that over-reliance on the so-called "customized basket" may introduce liquidity risk into ETF products and moral hazard of investment: the invested products deviate from the "original intention" of ETF, and most importantly, this operation invisibly increases the risk of index tracking error and will cause ETF investors to suffer financial losses.

Those who support customized delivery believe that this is very important to reduce the transaction operation cost of ETF industry. ?

This is because when the transaction price of ETF deviates from its indicative net asset value, it is not always possible to find urgently needed stocks in the right proportion. ?

Although the practice of using customized baskets is not new in the ETF industry: it has always been common in the European market; However, American regulators have so far asked many ETF managers to apply for exemptions to use their own customized ETF baskets. ?

According to the SEC, the main motivation for simplifying the regulatory requirements for customized baskets is to consider the time and cost required for ETF management companies to apply for exemption. At the same time, these regulatory roadblocks will lead ETF investment managers and regulators to play a cat-and-mouse game and realize the flexibility needed for ETF trading in other "opaque" ways, especially by completely replacing stocks and bonds with substitute collateral (such as cash). ?

The SEC pointed out that this is just to replace a risk with an equal or greater risk. ETF, which can replace securities with cash, may find that its performance is dragged down by cash factors, resulting in large tracking error and damage to customers' interests. ETF may be forced to directly buy or dispose of illiquid bonds and stocks to maintain its performance, thus exposing it to liquidity risk. ?

From the market point of view, a large amount of cash also means that the increase or decrease of ETF management scale has little impact on the overall market. ?

A study conducted by the Bank of Canada on February 20 19 19 found that cash substitution is becoming more and more common in American ETFs, especially in the field of fixed income.

At the beginning of the establishment of ETF, American regulators had almost no clear restrictions on the composition of the basic assets of ETF. However, since 2006, the SEC began to strictly restrict, standardize and supervise the structure and composition of ETF baskets, requiring ETF traders to construct the composition ratio of ETF actual transactions according to the portfolio holdings advertised, and only allowing ETFs to apply for exemption from using their own customized baskets in limited scenarios, which deviated from the established investment ratio and composition. ?

SEC is worried that ETF market makers will use their special relationship with ETF investment managers to build their own customized baskets, which will harm the interests of ETF shareholders and seriously affect the established policy of tracking ETF target index. ?

More specifically, the system will encourage the sale of securities with poor liquidity and people to choose to redeem securities with high liquidity in the process of ETF creation, which will bring the risk of liquidity mismatch in the financial market, and the liquidity of the whole ETF trading market will gradually evaporate like water in the scorching sun until it disappears. ?

In the period of market pressure, market makers may require ETF to provide cash instead of illiquid securities in exchange for ETF shares, which will affect the liquidity of ETF portfolio and ETF's ability to meet the cash redemption requirements of other investment customers other than market makers, and trigger a transaction liquidity crisis. ?

But the other side of the argument is that preventing or restricting customization will only increase the transaction cost and cost of ETF. ?

ETFs without customized basket flexibility usually need to buy a large number of individual designated securities. The SEC pointed out that this may lead to a larger bid-ask spread, and may reduce the market opportunities for arbitrage, thus causing the ETF with fixed proportion basket rules to be at a disadvantage in the competition with more flexible customized basket ETFs. This obvious trading disadvantage will prompt them to apply for exemption and allow them to use cash as substitute collateral. The SEC is worried that this will cause ETF performance to be "dragged down by cash" and increase tax exposure.

The new regulations issued by the SEC aim to make all ETF management companies compete fairly by simplifying the basket customization process of all ETFs. In order to effectively control the risks brought by this and stop the bad operation behavior, ETF market makers adopting customized baskets need to establish and improve the relevant internal governance structure including business system, operation process and risk management measures, and standardize the construction of customized ETFs. They must keep internal business records and appoint designated employees to ensure that customized baskets meet the regulatory requirements of the US Securities and Exchange Commission. All this is to prevent ETF market makers from overusing the customized process of this ETF basket and carefully concocting a very special portfolio, which is beneficial to themselves rather than the interests of ETF shareholders and may also hurt other market makers. ?

However, the SEC did not require market makers to disclose the specific positions of each institution's final customized basket. This means that due to the special customization procedure of ETF basket, it is still difficult for the whole market to track or understand the potential related risks of introducing portfolio positions. ?

The SEC's original idea was to require ETF management companies to publish information about such customized baskets on their websites every day, so as to "promote arbitrage by providing other ETF market makers with information about the types and quantities of customized basket positions that ETFs can accept on trading days". In addition, market makers who can't obtain the daily portfolio composition document (PCF) of ETF can obtain information through other new channels, compare the published customized ETF basket with their portfolios, assist in intraday hedging and estimate the cash balance. ?

But in the end, after intense discussions within the SEC, it finally chose to support the non-public disclosure of the specific position information of the customized basket, and rejected this reform measure that is likely to promote the great ecological revolution of the ETF industry.

SEC listed a series of rebuttal reasons issued by the industry, from claiming that mandatory disclosure "has nothing to do with secondary market investors" to thinking that it may cause unnecessary confusion in ETF industry; In particular, customized baskets may be mistaken for information about ETF portfolio positions. ?

Another argument is that public disclosure will delay the process of ETF and market makers negotiating the creation or redemption of customized baskets. ?

However, the real motivation to abandon the disclosure requirements of ETF customized baskets may be related to the panic in the industry. As the SEC said, forcing ETF management companies to release a basket of securities before accepting purchase or redemption orders may increase the risk of market participants (market makers and traders) trading the securities in the basket in advance or trying to copy the trading strategy of market makers, especially for ETFs traded in the day.

For the existing ETF market makers, publicly releasing the securities information in the customized ETF basket will break their huge trading advantage, because they have the privilege to access PCF files. ?

As Morningstar, an investment research company, pointed out in its comments on the new rules of the SEC's customized ETF basket: "We believe that the transparency of customized ETF baskets is very important for investors. Undoubtedly, ETF issuers need to maintain sufficient management flexibility and initiative, and can dynamically adjust the ETF investment composition ratio within a certain deviation range according to the real-time changes in the market. For regulatory reasons, all baskets used in a day's trading should be disclosed at least after the end of the day. This disclosure will help to analyze whether the customized basket of ETF is conducive to the market making and liquidity improvement of current market transactions, especially during the period when the market suffers external shocks. " ?

This is really the key. Trading is the conversion of information. Information asymmetry leads to serious market differentiation and unfairness. Unless the PCF information can be made public at least one day after the transaction, privileged ETF market makers will always be able to master more and more accurate trading information, including the feedback information of potential tracking error risks, as well as the problems and solutions in the process of ETF creation/redemption, which makes them in an unequal and favorable market position compared with most ETF investors, which runs counter to the original intention of SEC to promote the reform of ETF trading system. ?

Under the new rules of ETF trading, ETF market makers and investment managers can have huge independent space to deal with deliverable/cashable basket combinations as before. However, for analysts or the media, it is even more slim to find any potential risks brought by this freely customized ETF basket, whether it is tracking error risk or liquidity mismatch risk, because it is difficult for the public to obtain these important ETF trading data. ?

Concluding remarks

In the world of financial technology innovation, "sandbox experiment" has become an important trial and error mechanism and spread around the world. The essence of "sandbox experiment" is "anti-vulnerability", and the cost of trial and error is strictly controlled. Identify the costs and losses that may fail in advance, and proceed in an orderly manner within the risk preference and risk tolerance of investors; The probability of success is unpredictable, but the positive benefits it brings are enormous. ?

It is expressed in two words that traders often say in the trading hall of Wall Street: "If risks are well managed, profits will be managed by themselves". ?

The innovative trial-and-error thinking mode of "sandbox experiment" is applied to the traditional financial innovation model ETF, hoping to tap its greater potential and realize the second and third financial innovation leap. ?

The new historical era needs corresponding regulatory systems and measures. Whether the ETF transaction management mechanism launched by SEC is successful or not, the whole ETF market will wait and see. ?

To judge whether a regulatory system and measures really promote the development of ETF is to actually try, the skin in the game! ?

Time is the only prophet and saint, and only after the test of time can we get a true and correct answer.