What happened to commodity ETFs during the nickel-trading meltdown?
The recent suspension of nickel trading at the London Metals Exchange (LME) offered a case study on how ETFs behave during market disruptions.
The events of February 2022 led to widespread market volatility. One of the more spectacular impacts was the 250% price spike of nickel futures and the cancellation of trades on the LME.
While the handling of the crisis will likely keep City lawyers occupied for years to come, we wanted to shine a light on how commodity ETFs fared during the closure.
Most index providers do not have a fair value mechanism in their indices. Since indices are generally composed of liquid or at least transparently priced instruments, a price reference is generally readily available. In case of market suspensions, the last remaining price is commonly maintained in the index, at least in the short term. If it becomes evident the suspension will be prolonged, and that the suspended asset is unlikely to be tradable again, the asset is usually deleted from the index, either at the last price or with zero valuation. The latter was predominantly what we saw in the case of suspended Russia equities.
Fair value in physical and synthetic replication
In a physically replicated fund, where the fund holds all underlying assets directly, the investment manager is required to ensure that the net asset value (NAV) will not be over/understating the fair value of the fund. For example, maintaining the last traded price of a company that is undergoing bankruptcy would inflate the NAV. The fund would therefore be expected to align the NAV to ensure investors are treated fairly.
Things are a little more complicated for synthetically replicated ETFs, which use a swap counterparty to provide exposure to the index. Here, the NAV is predominantly dependent on the value of the swap. And herein lies the issue: if the index maintains a stale price of an asset, the swap will also be stale.
How can the fair value of the swap be determined if there is no reference price in the index? If there is doubt in the fair value of the swap, and by implication, of a fund’s NAV, how can clients be sure their holding is valued correctly?
Market disruption event mechanics
The below shows a normal synthetic ETF trade cycle:
- Clients purchase shares from a market maker (also called the authorised participant or AP) who quotes the real-time price on the exchange
- To cover the transaction, the AP creates share in the primary market at NAV
- ETF issuer purchases the additional swap exposure needed at respective index closing price
- Swap provider hedges additional swap exposure by purchasing the underlying exposure at the index valuation price
In a market disruption event (MDE), the swap provider is not able to effectively hedge the exposure they are providing. They still have a contractual obligation to pay the index return to the ETF, but are unable to correctly hedge, which will inevitably lead to profit or loss (PnL).
In this scenario, all parties are notified that the MDE process will be initiated. Under MDE, swaps are traded normally and fill on the published index level, regardless of whether the underlying assets are tradable or not. As soon as the underlying is trading normally again, the swap is revalued using the tradable level instead of the published level.
As a result of this process, the PnL incurred by the swap provider is passed on to the AP via a ‘true-up’ charge.
It’s all in the price
The bid/ask prices that are quoted on exchanges are driven by the fair price of the underlying exposure, demand/supply as well as the associated risk and cost of hedging. This is true in normal and disrupted scenarios. APs that misprice an ETF will find other market makers taking advantage because they can create/redeem in the primary market directly too. This arbitrage mechanism should keep ETF pricing fair at all times.
The nickel market disruption provided a real-life example. Below shows the NAV and price performance of a typical broad-based commodity ETF throughout March 2022. Normally, NAV and prices should not deviate significantly, though timing differences can cause some noise here.
The quoted prices are the market’s best estimate of the underlying fair value of the commodity basket. They price in the AP’s estimate of the true-up payable/receivable under MDE.
It is evidence that, while the NAV itself has been maintaining a stale value, due to the swap pricing discussed above, the ETFs were still continuously priced at a fair level. However, the ability to trade comes at a price: the exact true-up amount is unknown, so APs widened the spreads to compensate for the additional risk. Note the competitive forces keep the spread from widening too much.
We believe the transparent nature of ETFs and the presence of a secondary market may help maintain a level playing field for investors, even when underlying markets are disrupted.