Corporate Bond ETFs May Come Under The Regulatory Microscope

Judging from this framing by the Financial Times, an obscure debate over bond liquidity may prompt regulatory scrutiny.  Corporate bond ETFs may be a niche product, but anything described as “akin to Libor” deserves careful compliance scrutiny.

Corporate bond ETFs, like equity ETFs, issue shares that allow investors to gain exposure to an underlying.  All ETFs rely on arbitrage to align the price of their shares with the underlying.  Authorized participants can create ETF shares by acquiring baskets of the underlying, or buy ETF shares and redeem them for baskets of the underlying.

Under the SEC’s recent rule 6c-11 (the “ETF Rule”), ETF sponsors have discretion to compose these creation and redemption baskets.  Many ETFs compose baskets that correspond pro rata to their portfolio holdings.  However, they can sometimes create “custom baskets” not fully representative of their portfolio if doing so is “in the best interests of the [ETF] and its shareholders.”   Unlike typical equity ETFs, many corporate bond ETFs rely on custom baskets that include only a sample of underlying bonds, likely because the bonds are often illiquid and expensive to trade relative to equities.

Academics have now identified a potential correlation between the inclusion of particular bonds in custom baskets and the liquidity of those bonds in volatile markets.  Disagreements remain over causality: whether including a bond in a basket incentivizes authorized participants to reduce trading in that bond to avoid overexposure, or instead whether ETF sponsors include less liquid bonds in custom baskets to try to shift exposure onto authorized participants.

Regardless of which way the causality runs, the Libor comparison will attract attention.  The potential concern is clear: certain market participants may be able to customize ETF baskets in ways that increase or reduce the liquidity of particular bonds in volatile markets, potentially to the advantage of their own positions in the underlying.  Given the degree of scrutiny around market manipulation in the post-Libor era, corporate bond ETF sponsors may want to preemptively revisit their tools for ensuring compliance with the ETF Rule when utilizing custom baskets.