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Moody’s Report on ETFs’ Liquidity Warns of Systemic Risk

A research report from Moody’s warns that despite rapid expansion in the ETF sector, extended bursts of volatility could painfully highlight how ETF liquidity mirrors underlying market liquidity. ETFs track not only the performance of their underlying assets, but also the liquidity of these assets, says the report which also was covered by Bloomberg and the Wall Street Journal. Liquidity providers of ETFs are exposed to market, liquidity and operational risks and if these market makers step away from ETFs during periods of volatility, ETFs tracking illiquid markets, such as high-yield credit, are at increased risk of becoming less available and more expensive to trade. “These risks, when coupled with an exogenous systemwide shock, could in turn amplify systemic risk, a credit negative for market participants,” according to Moody’s. The report notes, however, that market makers are increasingly using trading technologies that may improve the liquidity of fixed-income markets. “[I]n the past five years, electronic trading of fixed income instruments has started to replace manual processes. The proliferation of alternative liquidity pools is likely to improve the liquidity of fixed income markets and ultimately the ETF ecosystem.”

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