The Road ahead for ETFs After the COVID-19 Crisis

ETFs — A tool for central banks to support the market

ETFs have proven to be an effective tool for central banks to tap into liquidity and support the market. Dating back to 2010, the Bank of Japan (BOJ) purchased ETFs to support the equity markets, without having to transact in individual securities.

In response to the market volatility and liquidity constraints during COVID-19, the BOJ increased its ETF purchases to more than 1.5 trillion yen ($14 billion) in March 2020.

Additionally, on April 30, 2020, the BOJ changed a rule within its program to link its purchases of ETFs to the amount of each stock available in the market. After having announced in 2019 that it would lend their ETF holdings to investors, the BOJ has now taken an additional step to improve liquidity in the market and minimize potential drawbacks to their ETF purchasing program.

Fixed income ETFs added to the Fed’s policy toolkit

On March 23, 2020, in an effort to offer stability and improve liquidity in the corporate credit market, the Fed announced that it would purchase corporate debt through a Primary Market Corporate Credit Facility (PMCCF). The Fed also stated that it would support market liquidity for corporate debt through a Secondary Market Corporate Credit Facility (SMCCF) by purchasing individual corporate bonds and ETFs in the secondary market.

The SMCCF began its ETF purchases on May 12, 2020 through a special purpose vehicle (SPV). The SPV initially received a $25 billion equity investment from the Department of Treasury, which can then be leveraged to a maximum size of $250 billion.

Eligible ETFs for the SMCFF include US-listed ETFs “whose investment objective is to provide broad exposure to the market for US corporate bonds. The preponderance of ETF holdings will be of ETFs whose primary investment objective is exposure to U.S. investment-grade corporate bonds, and the remainder will be in ETFs whose primary investment objective is exposure to U.S. high-yield corporate bonds.”¹

Exchange enhancements and resiliency

Despite the extraordinary market volatility and liquidity challenges during the COVID-19 crisis, the equity market structure performed well.

In the US, equity market structure enhancements that were implemented following the “flash crash” of May 6, 2010 and refined since the market events of August 24, 2015 helped to ensure that investors were able to trade ETFs with a high degree of confidence during the pandemic. The US equity market-wide circuit breaker mechanism was triggered four times and performed as designed. Additionally, several regulators and stock exchanges around the globe enhanced their processes and implemented new regulations to adapt to the COVID-19 crisis and improve market resilience amid extreme volatility. These changes include:

• Euronext & Nasdaq revisiting their (re)opening process In order to allow the market to open normally while providing participants with the opportunity to absorb incoming news, Euronext widened the volatility thresholds in some of its ETF listings on several days during the month of March 2020. Euronext’s regulators were consulted prior to the actions being taken.
  
  Following the marketwide circuit breaker trading halts in the US, on March 13, 2020, Nasdaq filed a proposal with the SEC to enhance the reopening auction process for Nasdaq-listed securities. The purpose of this enhancement was to align with the process currently employed following a Trading Pause initiated pursuant to the Plan to Address Extraordinary Market Volatility (i.e., the LULD Plan).
  
  
• Change in market-making obligations or incentives in London and Frankfurt On March 13, 2020, both market participants and registered market makers received notice from the LSE that in compliance with Rule 4102 of the Rule of the LSE, and taking into consideration global financial market conditions, the maximum spread requirements would be widened to 5% for all Fixed Income ETFs. These changes took effect at market open on March 13, 2020 and were subsequently extended by the LSE on March 16, 2020 to further include all ETFs.
  
  In order to encourage liquidity providers to continue their quotation activities during March 2020’s volatile markets, Deutsche Boerse rewarded them by doubling the achieved performance score during “High Volatility Quotation Days” (as defined by Deutsche Boerse in an external communication). Violations of Designated Sponsor performance requirements were subsequently not sanctioned in March 2020.
  
  
• SFC issued guidance on the oversight of ETF market maker activities In Hong Kong, ETF market-making activities by a liquidity provider were temporarily suspended after some traders were forced to undergo mandatory quarantine due to the COVID-19 outbreak. This subsequently raised concerns for the Securities and Futures Commission (SFC) with regard to the secondary market liquidity available to retail investors. The SFC alerted issuers to maintain active dialogue with market makers to gain a better understanding of their setup and make necessary preparations for ensuring business continuity, if and when it had to be activated, with a view to avoiding market disruption.
  

Overall, the measures implemented by exchanges and regulators were instrumental in promoting fair, orderly and resilient markets during the COVID-19 crisis. In the ETF space in particular, actions taken by exchanges to allow for more flexibility in terms of market-making obligations allowed market makers the ability to continue providing liquidity to investors.

Increased ETF usage in the aftermath of the COVID-19 crisis

The COVID-19 pandemic brought unprecedented challenges to markets across the globe, impacting liquidity across nearly all investment vehicles and asset classes. Despite these challenges, ETFs functioned as designed, providing market participants with liquidity when they needed it most. The staggering trading volumes during March 2020 illustrate how investors gravitated toward ETFs during periods of stress, with US-listed ETFs trading more than $15 trillion during the first five months of 2020, or 70% of their trading volumes in 2019.

• In 2019, ETFs represented 30% of all equity trading volume. SPDR ETFs represented 12%.
• In the first five months of 2020, ETFs represented 33% of all equity trading volume. SPDR ETFs represented 13%.

Given the important role that ETFs continue to play in providing liquidity and price transparency to the marketplace, particularly during stressed markets, we expect to see ETF adoption continue to rise and assets continue to grow.