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These People Are Ready to Pour Fuel on Burning Markets

5 | By Shah Gilani

Last week, I covered one of the major causes of the 1987 crash and how its modern counterpart is in an even bigger positions to tear down markets.

The other major cause of the 1987 crash was something called index arbitrage.

Today, that once-obscure market corner is insanely large, thanks to almost $4 trillion worth of ETFs.

Index arbitrage is simple, and it’s happening every second of every trading day. Most people just don’t know it.

Even worse is that it doesn’t always work. Sometimes it does the exact opposite of what it was built to do, like gravity suddenly levitating everything you think is grounded.

Here’s how ETFs and index arbitrage are going to pull the rug out from under the markets…

The Nitty Gritty of Index Arbitrage

In the old days, you might be able to buy gold in New York at $35 an ounce and sell it in London for $36 an ounce. That’s all arbitrage is, and it’s been around for as long as there have been stock markets.

Back in 1987, index arbitrage mostly referred to aligning the value of the S&P 500 futures contract with the value of the S&P 500 index itself. Traders mathematically determine if the S&P 500 futures contract is being priced in the marketplace at more or less than what the sum of all the stocks in the actual index is worth.

When futures expire, the value of the contract is exactly what the value of the index itself closes at on expiration day. In other words, they converge. But at any given moment, as futures traders and investors buy and sell futures, the value of a futures contract may differ from the value of the underlying index.

If there are a lot more buyers than sellers of futures contracts, like there is on a wave of good economic news, the value of the futures can be more than that of the 500 stocks.

Index arbitrageurs recognize this, buy the all the stocks in the S&P, and simultaneously sell a futures contract. That gives them an instant profit from buying something cheap and selling it for a higher price.

It goes the other way too. If futures are cheap, “arbs” will buy futures and sell stocks.

Today, while S&P 500 futures are still popular contracts, traders and investors have other ways to trade the S&P 500 index. Some ETFs track the index, including the SPDR S&P 500 ETF (NYSEArca:SPY), iShares Core S&P 500 ETF (NYSEArca:IVV), and the Vanguard S&P 500 ETF (NYSEArca:VOO).

ETFs trade on exchanges like stocks, but they act the same way the futures do. Supply and demand, buyers and sellers of the ETFs move their prices, and they may become more or less expensive than the underlying index they’re designed to track.

That’s when index arbitrageurs go to work, doing the same thing that index arbs did back in 1987 and have been doing all along, buying one instrument and selling another to make a locked-in profit.

It doesn’t matter if an ETF is based on an established index like the S&P 500, or the Dow Jones Industrials Average, or some group of stocks an ETF Sponsor thinks investors will want to buy in ETF form. ETFs are all indexed products. They’re packaged products designed to “track” underlying stocks or commodities, or whatever index they’re intended to be a substitute for.

And, yes, index arbitrage is conducted on all ETFs. How much and how often depends on how far an ETF price gets from the value of its underlying stocks.

The ETF Creation and Redemption Cycle

To understand what can happen when index arbitrage goes haywire, you have to understand how ETFs are created and redeemed, and how arbitrage is conducted while ETFs are trading in the open market.

Then you’ll see how the players in the ETF creation and arbitrage game are only your friends when things are going their way… and how they will tank the market to save themselves when a crash comes.

An ETF “Sponsor” (Blackrock and Vanguard are the biggest sponsors) engages an “Authorized Participant” (AP) to buy all the underlying assets needed to create an ETF.

The AP then deposits those securities with the Sponsor and, in exchange, gets “creation units,” 50,000 share blocks of the actual ETF. The AP breaks up creation units and sells those ETF shares in the open, or secondary, market.

Once ETF shares are trading in the secondary market, their price can go up and down without there being any more units created or destroyed. However, if more buyers want more shares than what are available in the market, APs must create more units (the same way a mutual fund must create more shares if more buyers expand the size of the fund). And, if sellers overwhelm buyers, sometimes ETF shares must be taken out of the market.

If there’s a supply/demand imbalance in ETF shares because there are more sellers than buyers, the AP must buy excess ETF shares from investors. Once the AP has 50,000 shares of the ETF, a creation unit, the AP redeems that unit with the Sponsor. In return, the AP receives the underlying securities that made up that creation unit of the ETF. The AP then sells those securities in the markets where they trade.

While APs are doing their creation and redemption thing, they are also conducting arbitrage in the open market, buying and selling ETF shares against baskets of their underlying stocks to profit from price imbalances. While they arbitrage for profit, the net result of the process aligns the ETF price with the value of the underlying stock prices, which helps an ETF track its index of underlying stocks.

Besides the APs in the primary market and the trading in the secondary market, there are other players in the secondary market trading ETFs. Market-makers of all kinds and liquidity providers all trade for profit.

In a Freefall, it’s Every Man for Himself

With almost $4 trillion worth of ETFs globally, and just shy of $3 trillion worth of ETFs traded on U.S. exchanges, everyone with skin in the game is busy.

On most days, APs easily control the creation and redemption of ETFs, and arbitrage keeps ETFs prices in line with the value of their underlying stocks. There’s money to be made doing all of it.

It doesn’t necessarily work that way when markets go haywire. Instead of aligning values, it can distort them or drive them down to who knows where.

It’s not conjecture. It’s already happened several times:

  • It happened as early as August 2007 in what became known as the “quant quake.”
  • It happened in May 2010 in what’s known as the Flash Crash.
  • It happened in August 2015 when some stocks and ETFs didn’t open. The ones that did dropped, some to a penny.
  • It happened again in May this year when one ETF, the iShares MSCI Brazil Capped ETF (EWZ) fell 19%. It didn’t crash because its underlying stocks fell anywhere near that much, because APs and arbs tanked it.

All of this happened because there’s something ETF sponsors don’t want you to know.

When stocks are majorly selling off, especially in a panicked way, APs and arbitrageurs and market-makers want out of the way. And when they leap out of the way, they lead the way down.

Take those APs. When sellers of ETFs overwhelm buyers and APs must redeem units, do you think they’re going to wait to get the underlying shares from Sponsors to sell them? Do you think they’re going to buy all the ETFs being sold, continue buying them at lower and lower prices, and not protect themselves from holding ETF shares and underlying stocks that are plunging in price?

Of course not. They’re going to sell what they hold ahead of what’s about to be dumped on them, and short-sell the ETF shares and the stocks coming their way. They’re going to try and profit from falling prices, which they are going to be driving down, so as to not go broke doing what they profited from in rising markets.

And the index arbitrageurs? They’re not going to arb falling ETF shares and falling underlying stocks, trying to pick off a small profit if they catch them being imbalanced. They’re going to do what index arbs did in 1987, they’re going to “dynamically trade” them both, and that means shorting them for profit. There’s no arbing a tanking market.

We know it happens. It happened in 1987, in 2007, in 2010, in 2015, in 2017, and it’s going to happen again. Only the next time, it could make the 1987 crash look like a day at the beach.

There’s something else going on, something so terrifying that regulators have outright lied about it.

On Friday, I’ll tell you what it is and why it is the guarantor of a gargantuan crash.

Sincerely,

Shah

5 Responses to These People Are Ready to Pour Fuel on Burning Markets

  1. Robert in Vancouver says:

    Sounds like index arbitrage should be banned. If it’s going to destroy the financial system and/or cost millions of people their life savings, then why let it continue?

  2. KA says:

    Wouldn’t the spreads between buy and sell prices limit the amount of arbitrage going on? These spreads widen more and more as the movement in the market increases.

  3. Michael Wild says:

    Shah, thank you for your insight that most of us need so much. Maybe you can help me understand why, if ETF’s are so clearly risky in this environment, some of your associates at money mappress are recommending them so much lately. Are they a good thing or should we be extra cautious? Thank you in advance.

  4. Jackie says:

    If I have a few long ETF’s and a few short ETF’s with equal values would I be protected during the next Flash crash.?

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