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US regulator probes ETF pricing
From the Financial Times of Sun, 21 Dec 2014 13:07:58 GMT

Extreme movements in the prices of bonds, commodities and other assets have prompted regulators at the Federal Reserve Bank of New York to take a closer look at the inner workings of exchange traded funds.

Wall Street’s top regulator has been talking to the firms responsible for ensuring the smooth functioning of such ETFs as it seeks to gauge the resilience of the structures to sharp fluctuations in the underlying market they track.

Two “authorised participants” contacted by the New York Fed said the regulator was concerned that prices of ETF units might significantly diverge from the value of their underlying holdings, particularly if the funds tracked less liquid assets or if they experienced heavy redemption requests.

A spokesperson for the New York Fed declined to comment.

The promise of quick and easy access to a wide variety of asset classes has encouraged both retail and professional investors to invest heavily in ETFs, with around $2.8tn under management.

ETFs seek to replicate the returns of securities or indices in a convenient wrapper that trades on a regulated exchange like stocks. They rely on authorised participants — investment banks and other trading firms — to create and maintain this wrapper.

Authorised participants said ETFs had performed well even in the face of oscillations in the price of assets such as currencies, commodities and corporate bonds.

“ETFs have been a good tool for price discovery,” a senior trader at one of the largest authorised participants said. So many investors were using the structures to dart in and out of hard-to-trade assets that the ETFs had become a better representation of pricing than the underlying cash market, he said.

But relationships between prices and asset values have been volatile. Shares in the iShares iBoxx high-yield bond ETF recently traded at a discount of almost 1 per cent to net asset value before surging to a premium of 1.3 per cent last week.

The Market Vectors Russia ETF saw its discount to net asset value jump to 5.8 per cent earlier this month, before moving to a premium of 9.5 per cent last week. The SPDR S&P Russia ETF this month reported both the biggest discount and largest premium since the fund was started about four years ago.

ETF market-makers cautioned that discrepancies might occur because the asset values were calculated at specific times, whereas the shares traded continuously.

The underlying holdings may also be very illiquid. Fitch Ratings found that about 54 per cent of the biggest bond holdings in a sample of fixed-income ETFs traded on every trading day between August and November, but only 5 per cent of smaller bond holdings did.

“In a period of prolonged stress this could be a risk because not all these bonds trade every day, whereas the ETF shares do,” Fitch’s Robert Grossman said. “If you have a high level of redemptions it could create a disconnect with the assets.”

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