Exchange-traded funds (ETFs) not only track the performance of underlying securities, they may also mimic their liquidity risk, says Moody’s Investors Service in a report published Thursday.
ETFs have enjoyed their rapid growth in a calm market environment, Moody’s notes, but extended episodes of volatility could reveal the funds’ vulnerability to underlying liquidity risk.
Specially, the markets for the underlying assets of credit ETFs, such as corporate debt, “show signs of declining liquidity,” the report says.
This may be compounded by the shift in firms involved with market making in the ETF tracking process to less-regulated, tech-driven trading firms from well-regulated banks.
“In the event of a liquidity drought in underlying markets, market makers would likely reflect this risk in their ETF quotes. So, in effect, ETFs track not only the performance of their underlying assets, but also the liquidity of these assets,” the report says.
“A stress event could diminish the amount of standing orders at various prices and reduce the perceived liquidity of the ETF market, even when ETFs are operating as designed,” the report notes.