THIS IS HOW ETF WILL REACT IN THE NEXT FINANCIAL CRISIS!

In the previous article we focus on some of the potential implications of the growing popularity of ETFs under the notion that they are better than the good old mutual fund simply because ETFs can be traded throughout the trading day. This is somewhat a true liquidity to the traders and ETF holders, but perhaps not so for the market makers.

One of the challenges or perhaps opportunities for market makers is that there will always be an period of arbitration every single trading day in that the NAV (net asset value) is only calculated at the end of day while public market trading happens throughout the trading days. By law, these makers can creation and/or redeem something called creation units to balance the price back to market equilibrium. So essentially, this lag in the real price discovery between the ETF's NAV and underlying assets is an arbitrary opportunity, which implies ETF market aren't all the liquid after all. This has even more implication on the bond ETFs as their NAV cannot be easily calculated on a daily basis versus the equity-based ETFs. Bond ETF accounts for ~35-40% of the total ETF market of $1.40-$1.70 trillion USD.

Imagine a situation in which ETF holders decide to sell ETFs at a price throughout the day that's way lower than the NAV, which is calculated at the end each trading day, these authorized market participants are then liable for the difference. If the selling persist for the next few days, liquidity, in which supply/sellers meet the demand/buyers, will dry us with no price discovery mechanism in place and/or these market makers are not willingly/simply cannot shoulder any more liabilities, the ETF market will come to a halt. Price discovery is important to kickstart to the supply and demand of the equity market.

Back in 2008, when buyers (who want to acquire equity with their cash reserves but aren't sure the price to enter into the market) and sellers (who want to sell at whatever price the market will give them) came to a halt given the confusion going on in the market, hence price discovery essentially came to a halt. The US Department of Treasury then set up the Public-Private Investment Program (PPIP) to kickstart the price discovery on mortgage securities and therefore demand in the market. This program is still not widely known and reported by the media to this day.

PPIP shows that market might venture into a state in which there is no equilibrium if demand (buyer buying at lower equity price) and seller (seller selling at a price higher than the buyer's demand) therefore causing liquidity to dry up. The arbitrary and illiquid nature of ETFs for market makers (somewhat liquid for investors in good times) might essentially create something similar in which the government has to step in the facilitate and kickstart price discovery in the market.

Liquidity in the market is good and plentiful when the times are good, but the arbitrary and illiquid nature of ETFs for market makers, not investors, has yet to be tested in challenge periods. All silver bullet appears brilliant at first until it is. Collateralized Debt Obligation (CDO) boomed in popularity by a magnitude of 10x in a matter of a few years before the crisis until it isn't brilliant soon after. Who knows if the popularity of the ETF is the real silver bullet of the decade preceding the Great Recession.

https://www.linkedin.com/pulse/implication-price-discovery-etf-hedge-illiquid-us-treasurys-hsiang/