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ETF/ETN Contagion

The fault in the transmission belt between exchange-traded funds and notes (ETFs and ETNS) and the fundamental assets they hold has spread from the gold funds to bonds. In order for ETFs to be tradable during the market day at something close to net asset value (unlike open-end mutual funds) there must be constant settlement between the ETFs and what they are investing in. The result is contagion risk hitting the underlying asset's market.

Institutional investors make money by creating or canceling ETFs during the day. They do this by selling or buying the offsetting underlying asset.

Last week the system went astray over municipal bond ETFs. An asset management arm of State Street Corp. (STT of Boston) in which I am a shareholder, temporarily stopped redeeming muni ETF shares for cash as frantic sellers tried to cash out in the wake of Ben Bernanke telling the world that the Fed would at some point wind down its $85 billion/month quantitative easing program, as should have surprised nobody.

State Street Global Advisors (SSGA), STT's asset management arm, told market-makers last Thursday that it would only accept so-called "in kind" redemptions for its suite of muni-bond ETFs. The dealers were not allowed to turn in the ETFs for cash for the rest of last week and also early this week. The ban did not apply to people selling the ETF on the market, only to institutions.

When panic selling occurs, typically broker-dealers deliver blocks of ETF shares to their issuer, in this case SSGA. It normally retires the surplus shares from the market while the dealers acquire the underlying bonds from SSGA. To get cash, dealers can pay a fee to SSGA which then normally sells the bonds on the market.

But that didn't work last week with relatively illiquid US muni bonds where trading was very costly (with big bid/ask spreads). So SSGA simply kept dealers from seeking cash lest it have to sell the underlying bonds for a big loss at fire sale prices. Apparently Citigroup did the same and possibly other creators of ETFs as well.

This would also cause the ETFs to stop matching the index they are supposed to track. The measure forced ETF institutional traders to do the selling themselves if they wanted cash.

The only alternative for them was to take the illiquid muni bonds onto their own books.

While the crisis in muni bonds has now ended and redemptions for cash have resumed, the effect on markets may continue and infect other illiquid corners of the ETF system especially thinly-traded bonds. Many fund groups offer both ETFs and closed- and open-end variants covering the same underlying asset class.

Debt issued by state and local governments, along with other bonds, are hurt by fear of rising interest rates and specific problems like the City of Detroit. That concern has now spread to other market players using Fed funds to finance different kinds of bonds. You can see it in the sudden jump in discounts from net asset value in bond funds not invested in munis at all.

Similarly, the earlier disconnect between the price of gold and the price at which gold ETFs traded spread to other ETNs invested in commodities, most of which are less liquid than the yellow metal. In fact, ETFs and ETNs may magnify market trends in panic periods.

Disclosure: I am long STT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.