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I am interested in the impacts of a debt crisis on the tracking ability of an ETF.

In particular I have read that the market makers for ETFs often take on large short-term loans in order to create or redeem large groups of shares of an ETF. This is conceivably necessary because purchasing the 50,000 shares of an ETF needed for redemption is not a small investment.

To what extent are market-makers dependent on loans to benefit from arbitrage in ETF-mistracking? And, in a credit crisis, would these sort of loans be expected to stop, or are they "reliable" enough that they would still go on?

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  • $\begingroup$ Maybe you could share the source for that information on the loans, so that it's easier to comment? $\endgroup$ – LazyCat Sep 9 at 21:58
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Market makers may take loans out to create ETF shares or redeem shares to repay loans. In my experience working with an ETF desk, that activity usually does not affect index pricing much. However, in a crisis it could lead to mispricings versus index futures if creation or redemption is restricted.

What you also see is that ETF market makers use loans (repos and other loans) for leverage to make markets and (usually temporarily) take positions. Those loans let them make markets in larger size which can close the gap between bid and ask if it is wider than they judge to be sensible.

Comerton-Forde et al (2010) show that credit conditions affect the tightness of market maker bid-ask spreads. Boudt, Paulus, and Rosenthal (2017) show that the bid-ask spreads also affect those loan terms. Together, these papers show causality flowing in both directions. Thus the loan terms (funding liquidity) and bid-ask spreads (market liquidity) are endogenous. The BPR paper shows that this endogeneity leads to a predicted effect of Brunnermeier and Pedersen (2009): the market behaves one way in a crisis and another way when stable -- and these are both equilibria. (The BPR paper also finds the threshold between these behaviors tends to happen near a TED spread of about 50 bp.)

Therefore:

  • the dependence on loans is real;
  • it affects creation/redemption as well as just plain market making;
  • a debt (or credit) crisis has effects that you will see in ETF spreads and liquidity; and,
  • that will affect market makers' ability to arbitrage away ETF mispricings.
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There are two types of loans involved in creating and redeeming ETFs:

  1. Stock or bond borrow / repo
  2. Collateral requirements for the creation/redemption process.

When you create and redeem ETFs you often don't have the perfect basket. Or you might take some time to accumulate the basket. You need to finance those positions using borrow (For shorts) and repo (for longs). These have a cost that the market-maker needs to pay.

When you actually do the create/redeem the shares all settle t+2. In the meantime you need to give some collateral to the custodian. That collateral needs to come out of the market-maker's treasury or get borrowed from the prime broker.

In both cases - a lack of financing will impede the business.

From my experience, in times of crisis the cost of the loans is the first to go up. Then the next step is a restriction in the amount of credit extended to the market-maker.

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