Comment by rndmwlk | Hacker News Reader

Comment by rndmwlk | Hacker News Reader

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>This gets a bit rambling but I am too lazy to edit right now.

No worries, as I said I'm interested so I appreciate the write up.

>Long story short, ETFs track NAV closer in more efficient markets. In less efficient markets, ETFs or any liquidity transformation vehicle usually lead the underlying because it's easier/cheaper to transact in them. From there it's price discovery on the underlying which happens at varying speeds and the process goes back and forth.

Totally get this relationship, that's not entirely where my question lies though.

>One of the reasons why the Fed decided to include ETFs in this facility is because the ETFs were trading at a steep discount to NAV at some points earlier this year.

So is the Fed just buying these ETFs in order to shore up this discount regardless of whatever they believe to be "true" NAV? Why would the Fed consider it important enough for intervention? Or are they really just at a point where they're truly raising the tide and this boat is getting more publicity?

There's a few reasons. The Fed's mandate to "promote maximum employment" has taken the form of ensuring properly functioning capital markets. ETFs not getting too dislocated from NAV is an important part of that because otherwise they become a useless hedging instrument. Lack of effective hedges increases volatility in markets and forces investors to reduce positions. Further reducing positions during a sell-off causes an even steeper sell-off, etc blah blah.

Additionally and more importantly, primary market transactions are priced off secondary market levels. During the sell-off and before the Fed intervened, corporate bond issuance completely vanished. A large portion of US companies are debt-financed and would be unable to finance operations or be forced to pay way higher rates without functioning debt markets. Ensuring both the primary and secondary market functions properly fulfills (in their theory) their mandate of promoting maximum employment because without either, a lot more companies would have gone under or laid off way more people.

>ETFs not getting too dislocated from NAV is an important part of that because otherwise they become a useless hedging instrument.

Sure, but that's only if we consider NAV to be "true" worth. To your point with the lack of liquidity in the underlying wouldn't logic dictate that the underlying needs to "catch up" so to speak?

In normal functioning markets, maybe? When stuff like the events of the past few months happen, markets just stop trading altogether. If there's thin trading in an already illiquid market, there's no mechanism that forces things to reprice. What you see as NAV did not reflect executable levels. That's why you saw bond ETFs trading at such a discount because those were the only things people were able to sell. In a lot of cases most people decided they'd rather short 25mm of an ETF at -x% discount and have it retrace to NAV par than sell 10mm bonds down -1.5x% and then the next 15mm at an even steeper discount. Crude example, not how bonds are quoted, and you probably would have to sell those bonds in way more trades than that but hope it serves as an example.

So, due to the liquidity issues the proxy market is essentially being used in place of the primary market and the Fed, understanding this better than I, opts to bolster this proxy market precisely because it is being used as a temporary primary market?

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