When ETFs Stop Working

the great Katie Garifeld. So in the first you're gonna be sitting on the ground at a train station for us as we record trillions where it's really like the world is in war mode right now, Eric, if if you're if, it's come to this UM, and there's some significant events that have been happening in ets that we're going to talk about on today's episode. What's been happening? Yeah, it's been pretty wild. Like you know, e T s are are like cockroaches. I mean, they can trade through anything,

and they have even when the underlying is frozen. But we had a situation with Russia where the underlying was frozen effectively and then also the e t F stopped trading. That's a new one. We've really never seen that before. It's really an important one to discussed because where does the sleeve investors and what should you think about going forward?

And then the other one is b x X, which is a fixed et N, which is Barclay's halted creations on that which it's still trades, but without creations, arbitrage is basically destroyed. And so the price d v H and the n A V and that causes problems and that we've seen before. That's sort of a classic. I'm a big bank, I don't feel like offering this anymore. Let me just all creations and that's annoying. I think.

I think there are two different situations, but they both speak to this idea of when the E t F stops uh doing what it does and I wouldn't say broken is the right word, but becomes impaired. Uh you know, how does that work? What happens? Joining us will be Key d Grindfield of Bloomberg News. She's also the co host of the newly launched relaunched E t F i Q Show as well as David Nodded with E t F Trends, this time on trillions. When E t F s stop working, Katie Dave Welcome back to the program.

Thanks for having me, Thanks for having me too. I feel bad, Eric that you had to change things around to accommodate me because I don't have a lot of answers. Listen, you're very busy, and you look I am happy to accommodate you. You just don't look comfortable. Well I'm not. I'm I'm sitting Indian style on marble and I'm about four feet from a dunkin Donuts kitchen. So but this is natural habitat for Eric. He kind of is back in the day. Maybe you're gonna have to stretch your

hip flexors after. Can I just say one quick thing about dunkin Donuts pretty pandemic. I would get the same breakfast here and then two years pasted because the pandemic, and then, as you mentioned, e t F I two started. I came back here on Monday two years later, got the same thing and it was actually a hair cheaper. Although somebody asked me to weigh the food. I was like, come on, I don't think. I don't think they're doing that, but I think don't donut. That's why the popular I

think they are able to be more efficient. But anyway, interesting tidbits there. I could say many things, and we're just gonna ignore that and move on. Um Katie, can we start with you what has been happening, because you've basically been on the front lines of the past few weeks as as all of these things have transpired, it's been pretty wild. I mean, it's been a roller coaster a few weeks, and I feel like a lot of the action has been centered on a bunch of e

t f s that aren't trading anymore. All of these um US listed Russian focused e t f s. Obviously, the Van Neck Russia et F was sort of where all of this action was concentrated. But I mean, as Eric alluded to, none, none of these et fs virtually, I think that's correct, are trading anymore. But before that happened, I mean, you saw a lot of flows into these funds. It's unclear whether that was a create to lens situation,

people trying to short it. You also saw options volume take off on a lot of these funds, including a fund I think it was a direction fund that announced that it would liquidate and it was a leverage fund. And you saw again options contracts just explode in volume, which we now know, and I'm sure we'll get into it's unclear whether those holders will actually be paid out. Okay, Eric, One of the e t F s that we want to focus on is called r s X, which is the van X Russia e t F. What happened with

that one? Yeah, essentially actually RSX and all of the politic creations, that's not that abnormal. Back ten years ago the Egypt et F pltic creations, when the stock exchange was closed for like two months, we've seen the before. We figured, oh, they'll just trade through. But the difference

here is this is serious government stuff sanctions. Also, the stocks stopped trading, the g d rs on those stocks stopped trading, and it became a much more like the e t F was thrust into a geopolitical situation, which it wasn't in the Egypt case. And so I'll actually turn over to Dave because what was different this case is the exchanges nicely and cbo E said we're not actually gonna get trade it either, and that was new.

I've never seen that. Normally e t s trade through anything, even if the underlying is frozen, and nobody writes about mechanics and busted mechanics better than Dave, So I would like to get his take on just what he saw and what he thinks, uh, sort of happened behind the scenes. Well, well, Joel was sort of saying before we got started that you only have me on when the car crash happens. So it does feel a little bit like that. I mean, you're right that this time was very different, and really

it comes down to the sanctions. I think if you want to trace it all the way back, it's not so much that the moss Go Exchange closed for business, because that's as you pointed out, that happened in Greece, that happened in Egypt. But in both those cases there was a really legitimate expectation that those markets would reopen, they might price differently, right, that the Arab spring could

have gone a couple of different ways. But I don't think anybody was expecting that somehow, you know, all of the companies listed, we're going to disappear. What happened with the sanctions kind of created this, I think, this cascading problem, which is once it became impossible for the Russian companies to actually do business as securities anymore, meaning that they could pay dividends, that they could pay their their bond servicing,

all of that stuff. When that became a problem, it was really just a ticking time bomb for when the LS the London Stock Exchange would effectively have to suspend the g d rs and the vast majority of Russian stocks that people trade trade in London as g drs, not in New York as a d r s, and not in Moscow directly. So once that happened, which was almost instantaneous, that in the early round of sanctions, that it was going to be impossible for these companies to

actually do business as global public securities. UM. I actually think they've waited about a day late. I predicted on Wednesday, two weeks ago that they would actually um either delist or suspend the g d r s. They haven't actually delisted them yet. I think that will be the next you to drop, at which point those no longer become investible securities, regardless of whether the market reopens if they

get delisted off the LC. So with no underlying security that anybody had faith in anymore, you know, pausing for halting creations and that you basically had to do that because there was no way to roll up a basket of securities anymore to do a creation and then the suspension of trading. That really comes down to the obligation of the exchanges themselves to ensure that they can make

orderly markets. Right, That's that's there on the hook for that if they let something trade knowing that it's going to be you know, hitting the limit up, limit down every eight seconds all day long because nobody has any idea how to deal with pricing that is on exchange a little bit, so you know, we didn't get it completely synchronized. I think RSX closed for trading a day after E r U S. But but fundamentally you end up in the same position, which is you have uninvestable markets.

That's what's different this time, Dave. And the pantheon of problems, which is sort of how I think about you. You're you're gonna be the red phone on the desk now for trillions and the pantheon of problems. Where do you

rank this in terms of et F history? Oh predates right, So the last time we can point to anything like this um is either Cuba or ran both before you know, both in the seventies and eight in the sixties prior to that, um, which was the last time we actually had the opportunity to look at the market and say, this just might not exist when we get out the other side of this crisis. UM. Now, I actually don't think we end up in a world where they actually

just obviate all foreign ownership in Russia. But that's on the table. They're already talking about taking over local assets

of foreign companies that have pulled out. I think it's really just a matter of time before they say and we're also obviating for ownership of the of the companies themselves, at which point, literally those stocks go to zero, right, those properties get written to nothing, which is incidentally what happened in Iran, and it is what happened in Cuba, which were the only two times in history I guess nineteen seventeen and Russia again. Uh, those the only times

in history that I know that this has happened. So it pre dates the et F structure. So if I'm a shareholder and I'm looking at that, this seems really bad. Yeah. Yeah, if you're sitting here with RSX in your SWAB account right now, Uh, the very very high likelihood is that you're going to get some very small percentage of your money back when RSX finally closes, when they finally liquidated it um, and you know it does have some cash. They did what they could to raise what money they

could while those markets were still trading. But at the end of the day, the price you see, you know, the price you last saw, is pretty close to what you might get, probably even less. Uh. And you know, as we as you guys mentioned in the beginning, I actually can't even predict what they're going to do with the options market, because that's crazy, because the options market

now has no way to settle. You mentioned a word, their liquid It's a big scary word, and I was going to ask, I mean, how does this end, these these e t f s where where trading has been halted, Can that be unhalted or do you see this ending eventually in liquidation. I only think that you'll see the Russian e t f s resume normal trading when you see the underlying markets resume normal trading. And I'm very, very skeptical that that's going to happen for US investors.

For for a forty act fund um. I actually think it is more likely at this point that those markets become truly uninvestable, and that even should Moscow reopen, the London will have to delist all those securities on the GDR market and nobody's gonna want to own the underlying s. E R U S had a lot of the direct underlyings. They moved in the last couple of days to put more of the A d r s and g d rs on the books. But even if that reopens, at this point, it won't have I don't think we'll have

those securities on the books any more. I think it'll be mostly cash. So let's say I hold r s X. A lot of people actually bought it after all this happened. Let's say they're training at three or four dollars. They bought it at five six whatever it was low. It was four months ago, so it's they're looking, Hey, it's a bargain you own that. E t F. Wouldn't you rather just have everybody sitting limbo until something gets resolved, even if that's two or three years, rather than really

get nothing. Yeah, I don't think you'll see them just decide like next Thursday, to roll up the fund. I do think you'll you'll see both. I mean, really, we're just talking about black Rock and Van Neck here. I

think you'll see them. Wait until there's a shoe going to drop right, whether either we you know, pass a piece of legislation that makes this permanent in terms of the sanctions, or Moscow does something to sort of obviate ownership, or the l s D lists all the g d r s, one of those kinds of events I think has to happen first. You're right right now, Today is not a day to close down this fund and hand everybody back a buck on their dollar, you know, you know,

a buck on their fifty dollar investment or whatever's left over. Um, why why would you do that? So one thing I think is you need to be a little cautious of though, is I think the idea that these are somehow cheap lottery tickets is really dumb. Like I don't think that you can look at the price of gas Prom when it reopens as some universal lottery ticket, because all assets must eventually be worth something. I think we're seeing a big shift in the fundamental economic order that's going on.

So I think that's a that's a bad call. Russia is not the land of meme stock, No, I don't think so. So on the lottery tickets ideas, I remember reporting on the fact that you saw that huge explosion both input and call volume, and it was described to me as just that cheap lottery tickets. And I mean, assuming that e t f s hadn't stopped working, I mean, especially for those put contracts, I mean it seems like they would have paid off though that actually that wouldn't

have been such a bad lottery ticket. Oh and I mean, Eric, you wrote about this the other day, right, I mean, there's actually a fairly substantial put heavy position that's due to settle what tomorrow I think on Thursday. I think that's right, nineties six million dollars or something like that, most of it on the put side that that should be in the money, Like to your point, that should be a lot of that should be in the money.

But because the o c C changed how they're doing the settlement where it's now I think has to be directed, meaning you have to go in and say yes, I'm willing to do I think a cash settlement on this um. I think there are a lot of folks that are gonna let these expire with the opportunity to have gotten money out of them, and and that's gonna that's problematic. That's not on like van AK, that's kind of on the O C C or CBO maybe, but like even there,

we are in pretty untested territory. So I think it's tough to point fingers. By the way, Dave, you mentioned the Barclay's of UH fund. That's v xx and e t N. What's different about that circumstance than the rs X one. Yeah, so totally different way that E T s UM sort of broke down a little bit over the last couple of weeks, so um vxx for very different reasons. Vxx is an exchange trade note i E. It's a piece of bank debt issued by Barkley's Bank,

tracking first and second month volatility futures. It's the most popular e T F where E T P I should say tracking volatility. It's sort of the traders darling sitting on about a billion dollars um and they suspended creations on it, which we've seen over and over again from E t N issue wers over the last decade um to the point where you know, I know you guys, now give it a you know, a red a red

traffic light in every situation. Um. And this is one of the big reasons, because it is a little bit of you know, a fit of peak that the bank can just decide they have too much risk on the books and decide to stop issuing new shares, which causes premium spikes, which is exactly what we've seen in v x X. It's exactly what Credit Suite did to t

VX uh basically a decade ago. Uh. And in that case, they just led a trade to a premium until they got comfortable again, and then they issued a whole bunch of shares out of inventory and in my opinion, somewhat feloniously probably booked the profit on that because they were actually issuing out of the market at a high price. UM. Let me jump in here, because uh, these banks, Uh, you're right, they do it almost when they want, and

that's what's annoying. In this case. Barclays did give some logic they said, well, we've run out of issuance capacity, but if you look at the documents, they are not out of issuance capacity. They have plenty of runway left. And so some speculated it's about hedging costs some who speculated that somebody made a clerical error with the structure products and this is sort of part of that fallout. There's also a theory that it could be the canary

and a deeper problem with their books. Uh, and somebody that management is just like, stop everything, what's your take on, what's really going on behind the scenes? Who pulled the plug and why? Well, so there are rumors on I mean I heard those rumors too, that there was sort of a blow up in some structure product issuance that had to get delayed. Um, and that puts some strain on the risk desk. And remember in the in the sort of a post Dodd Frank world, banks have to

actually manage their overall risk pretty carefully. And so every bank has somebody whose job it is to pay attention to how much VEGA exposure do we have, right, how much long equity exposure do we have, how much international currency exposure do we have? And in most cases they're monitoring that literally in real time to make sure that the bank doesn't get over at skis SKIS because they're

considered you know, important institutions by regulators around the world. Um, so it is not unlikely that somebody looked at their book and said, we have way too much long ball exposure on our book for the given volatility environment. Even though all of the E t N value of that was offset by an exactly equal liability in the E t N, that doesn't matter. That doesn't get to be counted because that's just considered short term paper on the book.

So there's a lot there's an asset liability miss match in terms of how banks have to account for these things. So it's not inconceivable they just got over their skis on risk. The sort of canard they put up of well we ran out of share issuance, that does happen like I mean, we know for a fact, for instance, that US Commodities Funds ran into this on U s O and I think on U n G a few times where they literally just didn't file to issue new

new shares. Unlike an e t F, a commodity spooler in E t N can only sell the shares it's it's actually registered with the exchange, and when they run out of those, they have to file for more and pay a decent amount of money. So every time they file for one of these extensions. It's like a hundred and fifty grand to put a bunch of new shares

up on the books. Now, it's possible for them to reuse shares that have been redeemed, but most banks don't, and I don't believe either Credits Weeks or Barkleys does.

So when we look at and say, oh, well, there's thirty three e t N three million e tns outstanding and they've got coverage for fifty the problem is if there has been a hundred million dollars in creations and a hundred million dollars and redemptions, they don't get to count that again, so they actually sort of use up only one side of the balance sheet when they're issuing. We don't actually know. You can't really impute it because the creation redemption numbers are net so we don't get

to really see the creation redemption. We get to see the net um. But I suspect either they let that happen on purpose to get out of this business, or the risk desk turned them down. Something that caught my eye with this v x X situation is just the ripple effects that it could have for the volatility market, largely because I don't know. You might look at the size of v x x and say, okay, it's like nine million dollars. That's big, but it's not systemically big.

But Goldman actually put out a note yesterday noting that if you look at the options market that surrounds v x x, uh the share a count of options is about or rather, the outstanding options on v xx are roughly six times v x x is actual share account. That is more than double the ratio of all but two e t f s, which is pretty amazing. Mean, it just speaks to that a lot of these volatility e t F c t N s, they're used as trading tools for a lot of these volatility players. And

I mean what this means for the liquidity. I mean, how could that options market around vxx be liquid if this e t N isn't really trading or wears are halted, it's still trading, right right, So so the share creation just means that it's going to disconnect from its fair value and it's mostly going to trade at a premium.

But to your point, you're right, like, the options complex around v xx is huge, and a lot of big hedge funds use that on a very dynamic basis what you're what, what you're seeing, if you're to monitor fin twit vol folks, the trader community there you're talking, you're seeing a lot of talking about moving to other vehicles, moving to other ways of expressing those opinions about VEGA.

But that that options expiration cycle, both in the VXX and really in the spy options and and the and the in the futures, like that really impacts volatility in pricing right the voulu you know, the whole sort of vallpenning around opex is a very real phenomenon. It's less of an issue in the VIXED complex than it is directly in the underlying indexes. But you're right, like this is it's a lot of shifting around of where that exposure is going to come from. In that shifting around

create the opportunities for hiccups. Um. One of the aspects of this is people who short the x X. So last we look, there was about fifty of the shares were held short the all creations, and man, you've gotta be they screwed them over because let's say your short this all of a sudden, it starts creeping up because other people who are short start covering, well they have they can't do creations. They gotta buy vxx open market. That really starts to lift the price quickly, and then

you panic you can start to cover. So all of a sudden, you're basically it's it's a you're in a race to just basically make sure you don't lose too much. Could they like sue the company because that's that's really the product not working as designed. Uh, not that anybody has these sympathy for short sellers, but they really they made a fair bet and they got they're getting screwed over interest. It was at six according to market numbers.

That's you basically just described the two fift t VIX lawsuit right, which when you know what they got sued for there, which was you know, we didn't you know, manage the product correctly and therefore reliable to cred suits won that lawsuit. So so, whether they morally should have or not, they won the lawsuit because they had appropriately disclosed everything they needed to disclose. I guarantee you that

Barclays is pretty much in the same boat. Everybody learned that lesson that this is a get out of jail free card. Um which is again why you guys put a red light on this thing, right, because this is always an option to your point about like all those people who were short, and whether they're screwed or not. You know, I guess the one thing against that would be that there are other products out there, right, so you know their BIXI exists, right, There is comparable beta

exposure available. It's not that difficult to roll up sort of at the hedge fund level, and exposure that looks just like vxx. So if you're short, you know at premium you can actually cover your beta on that completely just by buying vixie or by putting together your own rolling portfolio of those things. So I don't think that there's a systemic issue with that short position being there, but there's no question if you're sitting there on the short side, you have a really tough decision to make.

Do you cover up and make it worse or do you just hang on for dear life, noting that eventually this thing will crash back down to earth. What would you do? I get the heck out of it, like, I mean, it's I mean, I got a lot of questions from people like, oh, how do I play this premium blah blah blah blah blah, and it's like there are billions of dollars in very sophisticated hedge funds waiting for you to try, just desperate for you to try

to play this, Mr individual investor. By the way, sometimes I tweet about this and most people have the sort of understandable reaction, like call what it means, but really I don't know. Tenth reply is like, oh, I'm loving this. I don't know what they're doing, but they just some people just love when Like are they financial journalists because this, Yeah, that's true. These would be like people with like thirty five followers. I think they're like, they're definitely a day

trade there. There there is a there. I absolutely have seen the tweets from folks that we're using VXX in sophisticated vall hedge fund strategies precisely because they knew this could happen. Right, This was actually a feature, not a bug, because it only goes one way. Right, there's nothing you can do to be XX to make it traded at discount. Like that's not that's not how the real world works, and that would be unprecedented in the e t F world.

But you know, taking something that's an e t N having a pop to a crazy premium, that's free money for the folks that were smart enough to realize this is just a hanging chad over e t N s every day. If you were the SEC or you know somebody that control over this, where all the banks you could tell them, would you advise or regulate them to get out of the E t M business once and for all? Or is it okay to have this sort of graded our district where this can happen over and over.

You just live with it because, um, you know, if there's a market, hey, let people trade it. What do you think it's time to just get them out? Uh? What I'd rather see is for them to allow forty act structures to effectively create the same types of things like a lot of the pro shayers leverage and inverse funds, for instance, are just straight up forty act funds because they got in under the wire and they let them

manage them that way. There's no reason you have to put this exposure into an e t N. This exposure could very easily be in a straight up CFTC regulated commodities pool. Um So in this case, I don't see any reason for the e t N to exist. Uh. And the SEC has been I mean they've paid attention. Like I mean, over every couple of years, the SEC turns the eye of we're on towards the E t N market and waves their finger a little bit, you know, And to be fair, we are now down to a handful.

I mean, you and I remember Eric, you know, ten years ago there were dozens and dozens and dozens of all those E tracks E t N s that didn't trade, and like I mean, it was just it was a real littered field of garbage that you know, all had two million dollars in it never closed. Most of that's finally thankfully gone away. Um. But yeah, at this point, I would just think that it's better to shut these things down. I'm not sure anybody's really getting great exposure

out of them anymore. And if you want this kind of exposure is a wealthy investor. This is what structure products are for. Literally, these kinds of patterns of returns. Just one more wonky question. And the reason for using E t N over E t F told the same thing like fix or oil, is that the E t N is taxed in a way that's a little more like a stock, whereas the E T S holds futures

and taxation isn't as ideal, So is it is? The E t N popularity really just largely about this tax loophole, or I should say tax uh standardization with other ets. I think it's two things. So, yes, the fact that they're treated as prepaid forward contracts ie they get text just like stock. That was a big selling point back in the day, particularly around commodities E T N S before we actually had a lot of the commodities pool

ones out there. Um. I think that's largely obviated now because we've got great no K one commodity ETF and all that kind of stuff. Um. The the other one is frankly perfect tracking. Right. So the great thing about VXX if you're a vaultrator running a very tight quantitative strategy, is that you know what the indicative value is to the penny and it never varies. Right, It's mathematically guaranteed. When there was a viable creation redemption mechanism and it

was trading spot on, I have all the time. That's valuable. And this is a complex strategy with a daily roll. So there's a lot of opportunity for friction and miss on this. So having it in a perfect tracking vehicle like an et N makes a lot of sense. Dave.

One of the things that I just wanted to ask you here was interesting what you said about E t N S anything else that this episode has revealed that the market needs to be talking about more openly and consider changes or is this kind of business as usual in worst case scenarios. It feels pretty business as usial in worst case scenarios. I mean, we'd really do need to make clear that this was a conversation in two chapters.

What's going on in v x x UH and the other barklays et N that's shut, which is O I l um. That is an extraordinarily unique thing to e t N s issued by the two big banks that really still issue e t N s um and it is the most problematic edge of the EXTREMEE traded product landscape. That has nothing to do with what's going on in Russia, even though we are talking about suspended you know, creations in both cases, what's going on in Russia strikes me as a little bit more like a two year flood.

I I would not have expected to see this in my lifetime, and I don't particularly expect to see it again in my lifetime because it requires, you know, literally the overnight turning of a major economic player into a pariahs state. I don't think we're going to see that again in the next twenty years. I hope. Right. Well, you've bring up the emergency markets, so we didn't really get to that. But like you know, this is why the cold emerging I mean, they are dangerous. The governments,

some of them authoritarian. I will say this is probably you know, we've had first toll on her F R, D M, E TF talk about in et F. It keeps getting justified and justified. No China, no Turkey. It really is true. All the problems are from governments with authority, authoritarian sort of you know, not dictators, but just governments can just do whatever they want. Um, it's an interesting time for that fund. I think it would probably grow after this. But I do think the emerging markets, especially

with China, it's gonna get it now. China is going to be even bigger in e M, and I don't know, I can feel like the whole emerging markets complex or it gets unbundled or shifted around. I don't know this. Do you think this is a game changing moment. I think I've already said they're they're killing the acronym brick at some point. Yeah. I I'm not a big fan of the idea of bricks or bicks anyway, but but yeah, I think this puts a spotlight on what we mean

by emerging markets. I think a lot of people, particularly financial advisors, have treated e m as as a monolithic bucket. Right. It's just a pattern of returns you put in the corner of your portfolio. You put eight percent in it, and everybody's happy. Um. And what we're learning is, though there's a huge difference between Russia, China, India, Brazil and

all of the other emerging markets, they're all individually very unique. UM. I'm a big fan of Perth product f R d M. I think it's a really great way to to to spin this UM. But I think what we also saw was when we all the major emerging markets ets had to pull Russia out because the index providers called those

market Russia uninvestable. Again, there was a lot of I think legitimate hand ringing there that the optionality of whether or not those Russian stocks might someday be worth something was being taking out of the hands of an existing e e M or vw OH shareholder. That's a legit complaint, but it's a complaint about indexing and that and I think that's a really important thing if you're in an actively managed emerging markets mutual fund right now, they must exist.

I can't think I went off the top of my head. Whether or not you were in Russia is a choice that your PM made, right so that like you voted for that PM with your dollars. I don't think most people who just threw money into EM or v w OH spent a lot of energy thinking about whether they were enough foot see or MSc I index and what was going to happen on you know, whether this country

was going to get in or out. You know, we talked about it when countries, you know, try to get into the emerging markets, but like this is a big getting out and that's been you know, a long time coming. We haven't seen that before, all right, Dave. Usually I asked for favorite tickers. We've done that before with you. Um, I want to ask you what's your favorite E M ticker. Well, I mean I already said it Freedom f r d M Alpha architect Freedom one hundred. I get that right.

I don't even remember if I got the name of the fund right, but it's that far d M and it's the only, it's really the only interesting emerging markets fund out there. It's the only one doing something really different. Dave, Katie, thanks for joining us on Trillians. Thank you, thank you. Thanks for listening to Trillions. Until next time. You can find us on the Bloomberg Terminal, Bloomberg dot com, Apple Podcast, Spotify, and wherever else woul you'd like to listen. We'd love

to hear from you. We're on Twitter, I'm at Joel Webber Show. He's at aer Fultunice. This episode of Trilliance was produced by Magnus Hendrickson. Francesca Levi is the head of Bloomberg podcast Fight