‘People Are Going To See There’s No Liquidity’: EM ETFs Face ‘Minsky Moment’

Back in April, we brought you something called “CitiWide Change Bank Is Back: Emerging Markets ETF Edition.”

In that post, we lampooned (for the umpteenth time) the ridiculous notion that you can explain away an absurd underlying business model by citing “volume.”

That argument is popular among those who defend the liquidity mismatch inherent in HY and EM bond ETFs and the best way to illustrate why it’s silly is to refer readers back to a classic 1988 SNL skit about a fictional bank called “CitiWide Change Bank.”

The bank’s business model was simple: you bring them one denomination and they’ll give you any kind of change you want. The punchline comes from one of the bank’s executives who says this:

People ask us all the time: how do you make money doing this? The answer is simple: volume.

Clearly, that’s laughable – and everyone watching SNL in the late 80s understood why.

Well, a whole lot of ETF investors don’t understand how that applies to HY and EM bond funds.

The bottom line is that the ETFs promise daily liquidity but the underlying assets simply aren’t that liquid. And those underlying assets don’t become any more liquid when trading in the ETF picks up. In fact, the opposite is true. The more trading shifts from the cash market for the bonds to the ETFs, the less liquid the bonds become and the greater the liquidity mismatch becomes.

FT took up this issue as it relates to EM bonds in a new piece out Monday.

This liquidity mismatch is a major concern given the sheer amount of money that’s flowed into EM this year. “In the first half of this year, ETFs investing in EM bonds took in $13.5bn, according to EPFR, a fund flow monitor — smashing last year’s record of $11bn,” FT notes.

But think about the backdrop for this. We’ve been over this time and time again. You’ve got DM central banks looking to roll back accommodation (so rising DM rates), you’ve got the situation in the Korean peninsula, you’ve got the political turmoil in Brazil, you’ve got the always dicey situation in Turkey, you’ve got the uncertainty surrounding crude prices, you’ve got China deleveraging, and you’ve got an EM rally that’s stretched to the absolute breaking point.