ETF Issuers Quietly Prepare For "Market Meltdown" With Billions In Emergency Liquidity

Tyler Durden's picture

Between the dramatic sell-off in German Bunds that unfolded over the course of three weeks beginning on April 21 and the erratic trading that ensued on Tuesday following the weakest JGB auction since 2009, the chickens, as they say, have come home to roost in government bond markets where thanks the ECB, the Fed, and the BoJ’s efforts to monetize anything that isn’t tied down, the market has become hopelessly thin. 

As we’ve documented exhaustively — and as every pundit and Wall Street CEO is now suddenly screaming about — the secondary market for corporate credit faces a similar dearth of liquidity and at just the wrong time. Issuance is at record levels and money is pouring into IG and HY thanks to CB-induced herding (i.e. quest for yield) and record low borrowing costs (again courtesy of central planners), but thanks to the new regulatory regime which ostensibly aims to curtail systemic risk by cutting out prop trading, banks are no longer willing to warehouse corporate bonds (i.e. dealer inventories have collapsed), meaning that in a rout, investors will be selling into a thin market. The result will be a firesale.

So while policymakers are still willfully ignorant when it comes to honestly assessing the effect their actions are having on government bond markets, the entire financial universe seems to have recently become acutely aware of the potentially catastrophic conditions prevailing in corporate credit. These concerns have now officially moved beyond the realm of lip service and into the realm of disaster preparedness because as Reuters reports, some of the country’s largest ETF providers are arranging billion dollar credit lines that can be tapped to keep illiquidity from turning an ETF sell-off into a credit market meltdown:

The biggest providers of exchange-traded funds, which have been funneling billions of investor dollars into some little-traded corners of the bond market, are bolstering bank credit lines for cash to tap in the event of a market meltdown.


Vanguard Group, Guggenheim Investments and First Trust are among U.S. fund companies that have lined up new bank guarantees or expanded ones they already had, recent company filings show.

The measures come as the Federal Reserve and other U.S. regulators express concern about the ability of fund managers to withstand a wave of investor redemptions in the event of another financial crisis.


They have pointed particularly to fixed-income ETFs, which tend to track less liquid markets such as high yield corporate bonds or bank loans.


"You want to have measures in place in case there are high volumes of redemption so you can meet those redemptions without severely impacting the liquidity of the underlying securities," said Ryan Issakainen, exchange-traded fund strategist at First Trust…


Under the Wall Street reform act known as Dodd-Frank, banks have been shedding their bond inventories, resulting in less liquidity in fixed-income markets. Because there are fewer bonds available for trading, a huge selloff in the bond markets could worsen the effect of a liquidity mismatch in bond ETFs.


Vanguard, the second-largest U.S. ETF provider, lined up its first committed bank line of credit last year and now has a $2.89 billion facility backed by multiple banks and accessible to all of Vanguard's funds, covering some $3 trillion in assets, the Pennsylvania-based fund company told Reuters. The new setup is to "make sure that funds will be available in time of market stress when the banks themselves may have liquidity concerns," Vanguard said.

Essentially, ETF providers are worried that in a pinch (i.e. when ETF sellers outnumber ETF buyers), they will be forced to liquidate assets into structurally thin markets at fire sale prices in order to meet redemptions, triggering a collapse in the underlying securities (like HY bonds). In the pre-crisis days, this would have been mitigated by banks’ willingness to purchase what the ETF providers are looking to sell, but in the post-Dodd-Frank world this isn’t the case so the idea now is that bank credit lines will essentially allow the ETF providers to become their own dealers, meeting redemptions with borrowed cash while warehousing assets and praying waiting for a more opportune time to sell. 

In case it isn’t clear enough from the above that ZIRP is in large part responsible for this, consider the following:

"These funds offer daily or even intraday liquidity to investors while holding assets that are hard to sell immediately, thus making the funds vulnerable to liquidity risk," U.S. Federal Reserve Vice Chair Stanley Fischer said in a speech in March in Germany, pointing directly to ETFs and saying they have mushroomed in size while tracking indexes of "relatively illiquid" assets.


That is all exacerbated because investors have been pouring money into bond ETFs, while banks, under regulatory pressure to limit their own holdings, have been slashing their bond inventories.


Growth in fixed-income ETFs also means there are now more products tied to corners of the bond market previously untapped by ETFs. Assets in U.S.-listed fixed-income ETFs are up nearly six-fold since 2008, to $335.7 billion at the end of April, according to Thomson Reuters Lipper data.

And why, one might ask, are investors suddenly interested in exploring “corners” of the bond market where they had previously never dared to tread thus creating demand for ever more esoteric ETF products? Because when risk-free assets are at best yielding an inflation-adjusted zero and at worst have a negative carry, investors are forced into credits they would have never considered before just so they can squeeze out some semblance of yield without simply dumping everything into equities. 

Of course liquidity protection comes at a cost:

Banks facing their own reserve requirements against these lines are charging commitment fees that can range from 0.06 percent to 0.15 percent, according to company filings. If a line is actually drawn upon, there would be additional interest charged on any amount borrowed. In many cases, these costs are included in the ETF's annual expense ratio, and borne by the funds' investors.

To recap: central banks have created a hunt for yield that's driven investors into fixed income categories they wouldn't have normally considered, creating demand for ever more esoteric ETF products. Thanks to curtailed prop trading, the market for the underlying assets is even thinner than it would have otherwise been, meaning fund managers would be forced into a firesale should a wave of redemptions suddenly rear its ugly head. To mitigate this, ETF issuers are setting up credit lines with the very same banks who in the pre-crisis world would have acted as liquidity providers. The cost of these credit lines is passed on to investors via higher expense ratios meaning fund holders can go ahead and shave another 15bps off of their fixed income ETF returns which are already pitifully low thanks to ZIRP.


In the final analysis, these liquidity lines are essentially distressed loans when drawn down, and the effect is to create yet another delay-and-pray ponzi scheme whereby liquidation is temporarily forestalled by borrowed money.

Recall that Howard Marks recently warned investors against ignoring the fact that an ETF can't be more liquid than the underlying assets and the underlying assets can be highly illiquid. So while Marks may have wondered rhetorically what could happen in a worst case scenario, the market is itself now quietly taking steps to avoid that moment as long as possible


Comment viewing options

Select your preferred way to display the comments and click "Save settings" to activate your changes.
cuttlefish's picture

I do not see what good that will do last time we saw credit markets freez up at the first sign of panic ..

MonetaryApostate's picture

Looks like their plans are coming around quite rapidly now, war is on the horizon, economic collapse, militarization of police, and of course that begs us to ask, what's next?

Imagine tomorrow...

Pladizow's picture

For all those who missed out on a bullshit 5 year ride up, this is your chance to capitalize in a much shorter time frame - short all government debt!

kliguy38's picture

beware playing any paper games when this ponzi comes apart......they'll wipe you out,,,,they won't let the "little people" collect....

Waylon Bits's picture
Waylon Bits (not verified) Pladizow May 13, 2015 1:42 PM

True but we think your chances of strolling down to the bank and collecting on all those "winnings" are well.... slim.

NotApplicable's picture

Yes, but they had a much smaller lever back then.

Now, who wants to be the fulcrum?

PartysOver's picture

The Federal Reserve will step in with some sort of Special Investment Vehicle (Off Balance Sheet of course) that they plucked out of their arse to fund the EFT Creators to absorb any panic selling.  The 0.01%'ers will be very happy so all will be good to go for new all time highs.  The Ponzi will not die until the CB's are cremated.  And the CB's will not be cremated until the Large Banks, aka CB Stock Holders of the CB, start to turn on each other.

Squid-puppets a-go-go's picture

absolutely correct.

Collapse comes only when the oligarchs start trying to dupe each other out of the lifeboat's queue

bluskyes's picture

haha, perhaps the fed's goal is increasing leverage to such an extent that the fulcrum is crushed.

NoDebt's picture

That was my first thought as well.  2008 the banks shut down those credit lines so fast almost nobody who needed to tap theirs could use it.  They were completely freaked out about their counterparty risk (never being repaid because the institution using the credit line goes insolvent over a weekend).  Sort of the definition of a credit market "freeze".

Also, I wonder how much of this is directed towards supporting much more pedestrian funds in the event of crisis, like, say, the recently revamped rules on stodgy old Money Markets?  There's still a ton more money in those dinosaurs than there are in HY, for example.  And we all remember that the shit really hit the fan after a Money Market fund "broke the buck" in September, 2008.  (Certain types of Money Market funds are now/shortly will be floating NAV, not $1 as was traditionally always the case.  Regardless, breaking the buck on one of them would definitely unleash the Kracken again.)

Great article, though.  Good sleuthing by the Tylers on this one.


NoDebt's picture

Exactly.  I couldn't remember the name of it off the top of my head.  6 years will do that to you.

Money Markets have a TON of money in them, but if they break the buck, it won't be by 20%, like a HY bond fund easily could.  It'll be by 1-2%.  On the day the Reserve Fund "broke the buck" back in '08 I think it was like $0.97 and change closing NAV.  (Again, from memory so don't quote me.)

ZH Snob's picture

one complication that will shock and confuse the fleeced is that when this baby blows the actual value of the currencies will be going with it.  no one will be able to tell what a lot of money even is at that point.

Fred Garvin's picture

Interesting comments from some investors in HY corporate bonds...

Burt Gummer's picture

That's why they will never raise rates, QE infinity forever until hyperinflation.

ZH Snob's picture

hey guys, I've got a great idea for when this beast melts down and everyone is desperate.  let's get together a load of good money now to chase after the bad money later.

Vergeltung's picture

sounds financially sound.


KnuckleDragger-X's picture

Economic suicide...Funny, I don't remember any time where I volunteered for a suicide mission.....

Beam Me Up Scotty's picture

The day you were born, you started to die.

madcows's picture

sorry pal.. you were enlisted.  you didn't know it, but the government drafted you for the Crack Debt Suicide Squad.

thatthingcanfly's picture

I made it through the first sentence.

I like it when my chickens come home to roost. They usually head for the coop at just before sundown, after eating bugs out of the yard all afternoon. I'll lock up the coop; then come back in the morning and I'll have some fresh eggs they laid for me.

What was this about again?

SuperVinci's picture

You got you some weird birds then. Mine lay in the day and roost at night in the coop.

thatthingcanfly's picture

I think mine lay in the day too. Morning is just the time when I check for the eggs.

I'm new to raising chickens. Got a pair of Rhode Island Reds about a month ago. What have you got?

valley chick's picture

RIR's myself. You can have them laying anytime during the day.  Been good gals and pretty hardy to both hot and cold temps. Will be culling tomorrow and looking to replace with heritage gals. 

froze25's picture

Mine lay in the day, but roost at night on top of the coup unless its the winter and cold out.  Black Austrolorps and Golden Buff Orphentons.

Perseus son of Zeus's picture

This is starting to get scary! Stop scaring Perseus son of Zeus!

jim249's picture

2.89 billion to cover for 3 trillion????????????

knukles's picture

Beats the shit oughta fuck all zip zilch nada zero
Mom, when I can I start playing with myself?
When your father gets home, Billy.

combatsnoopy's picture

it's that hyper rehypothicated doozie!  

The Wise owl on Winnie the Pooh says, "look!  I'm walking on air!"


Who Laughed's picture

only enough to cover 0.01%

madcows's picture

So, why should anyone loan money to a corp. so that they can buy their own stock, and line the CEO's pocket?

Fuck that.  I'll just buy their stock instead.

Or, better yet, i'll take the money and pay off the wife's car loan.  FU CB.  you reap what you sow.

MedicalQuack's picture

What an exciting time to begin exploring the possibilities of becoming an "unbanked" consumer:)


Perseus son of Zeus's picture

I bet the dollar will crash and too bonds as the Axis of Asian Evil silk road bank will accelerate any possible down turns by selling off their dollar and bond holding making a flight to safety appear to be a losing proposition.

Oh yes this time it will be real. Uncle bully Sam has been exposed and guess who's under that costume?

allgoodmen's picture

Now's a good time to start, but you can never completely unbank. For instance, your pension fund and/or social security is probably going to be, at least in part, in derivatives of these ETF credit lines.

MajorFall's picture

Which is exactly why as QE3 was in full force, we should have left the zero bound (if only by a token amount) essentially saying we are providing CHEAP liquidity but not FREE liquidity..

Dr. Engali's picture

Why bother with liqudity lines for redemptions when they can just lock them down?

Winston Churchill's picture

"Closed for WWIII' on the door.

Winston Churchill's picture

Seems  they're running out of time on that front as well.

As you like to say: tick tock.

Beam Me Up Scotty's picture

IMO, the Fed will just print moar, and activate the PPT.  They won't tell you they are doing it, they will just show everyone the propaganda charts they make.  How does anyone know what the Feds balance sheet truly is?  When dollars are laying around like grains of sand, the Fed will still be telling everyone their balance sheet is 4 trillion.

NoDebt's picture

It's not the Fed's balance sheet that's the problem in a crisis event (worse case, they could just declare that the normal rules of insovlency don't apply to them during a "national financial emergency".)

The problem is everyone ELSE's balance sheet.  The cascade can affect (non-bank) companies too fast for the Fed's printed money to make it to them.  Lehman went bust in a weekend.  If they had made it to Monday morning they might have survived.  When Lehman's debt was written off by the Reserve Fund Money Market, it caused them to "break the buck" and with that, full panic was on.

As with most things, it's like a big game of logisitcs.  Having limitless printed money is only one part of the equation.  Getting it where it's needed is the other half of the logistical problems.  And there's nothing stopping those transmission channels from freezing up just as they did in 2008.

Beam Me Up Scotty's picture

Ya but today, it can be wired in the time it takes to make a few key strokes on a computer.  In 2008, we still had some semblence of capitalism, and they let it fail.  Today, I don't think they will do that.  They can basically pencil whip any number they want to with the ability to make unlimited fiat.  If the market tanks now, its because they let it tank---and maybe thats their plan.  Not sure the politicians will like to hear the howl of their constituents however.

Winston Churchill's picture

That will be the signal for the RoW to finally dump the USD.

All that preparation will not go to waste.

They want the FedRes to give them a reason to justify it..

NoDebt's picture

Wire transfers existed in 2008.  As for letting Lehman go being a political decision....yeah, to a certain extent.  I think there was an element of lost control, as well.  They didn't understand the extent to which Lehman had been covering up the truth of their situation for months since the implosion of Bear Stearns.  It was murky and complicated.

But Bear Stears?  Absolutely, that one was an intentional decision to let them go.

Anyway, I'm pretty sure they're going to lean more heavily on shutting stuff down, limiting withdrawals and those sorts of schemes next time around.  And they'll find it might even be WORSE.  If you limit things by shutting markets and forbiding withdrawals now you have ZERO liquidity.  You can't access ANY of it, no matter how depressed the price.  And that will unlesh a whole different type of crisis that I doubt they're prepared for.

LawsofPhysics's picture

Please, such "let the majority eat cake" monetary experiments have been tried before.  The outcome will be no different this time around, just the size and the scope will be much, much larger.

For those of us that produce real products of essential value to maintaining a high standard of living, we have very real inputs and input costs.  These margins are pretty tight as far as I can tell.  Eventually you paper promises will not cover my inputs and I will stop producing.  You can have all the fucking paper in the world, but if I have the last can of beans on earth, well, my family and I eat.

Once the supply line break in earnest, then you'll see the usless paper-pushers start turning on each other and their political puppets, not before.

Beam Me Up Scotty's picture

I agree with you guys.  All I am saying is, the illusion of a dollars worth can be maintained far longer, if they don't tell us exactly how many dollars actually exist.  In the meantime, they can try and paper over any kind of market crash if they so choose.  Lehman may have caught them off guard, I don't think they will let that happen to another big bank.  But who the hell knows, I should have listened to Robot Trader 5 years ago, and went all in.  Im no great swami thats for sure.  And if they are creating a ton of money, what better way to meter the flow of it than to have capital controls at the bank.  You might be a millionaire, but if you can only take $300 out per day, you aren't any different than the schlub who has a few grand in the account.  Thats one way to "shrink" a large monetary supply.