What ETFs, illiquid assets, and fire sales requires
This paper documents several facts about exchange-traded funds (ETFs) holding corporate bonds. The main empirical finding is that bond ETF baskets contain a small fraction of holdings, a fact referred to as 'fractional baskets,' which contributes to persistent discrepancies between ETF price and net asset value (NAV). For ETFs holding corporate bonds, roughly 10% of holdings are in creation baskets and 20% are in redemption baskets, on average. This challenges the common assumption that baskets are representative of holdings and has important implications for the ETF arbitrage process. These fractional baskets also exhibit high turnover, and their composition differs from overall holdings in terms of duration and bid-ask spreads. The paper develops a model to show that these discrepancies may be a feature of ETFs holding illiquid assets. The model demonstrates that an ETF’s authorized participants (APs) can act as a buffer between the ETF market and the underlying illiquid assets, helping to mitigate fire sales. When facing redemptions, an AP holding bond inventory endogenously avoids a fire sale because selling bonds at fire sale prices would lead to large mark-to-market losses on their existing inventory. This allows the ETF price to fall while avoiding selling bonds in quantities that would trigger a fire sale, insulating non-redeeming investors and the underlying bond market from immediate pressure.
Pillar: Crypto & Sovereign Finance · Authority: Bank for International Settlements · Version: 1.0.0 · Last updated:
Primary source: https://www.bis.org/publ/work975.pdf
SHA-256 integrity: 84e73843c18c59c546ea1aa601d89ab746c3536719b323e94c300601a50adb6e
Primary Citations — 7 traced to source
- Abstract: First, the portfolio of bonds that are exchanged for new or existing ETF shares (called creation or redemption baskets) often represents a small fraction of ETF holdings - a fact that we call "fractional baskets."
- Section 1: For ETFs holding corporate bonds (i.e., illiquid assets), we find that roughly 10% of holdings are in creation baskets and 20% are in redemption baskets, on average.
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