ETFs are the canary in the bond coal mine

Exchange traded funds deserve more scrutiny in light of March’s market turmoil

Gillian Tett

The way ETFs were used during the market drama that unfolded as Covid-19 spread worldwide offers some curious micro-lessons
The way ETFs were used during the market drama that unfolded as Covid-19 spread worldwide offers some curious micro-lessons © Ingram Pinn/Financial Times



Ever since the 2008 financial crisis, policymakers and pundits have wondered what would happen to the cogs of finance in the next big global market shock.

Now, they have a test case to dissect: the widespread market drama that occurred in March as Covid-19 spread worldwide and economies began locking down. While it is still too early to pass definitive judgment on the overall resilience of banks and finance — since the full tally of Covid-19 pain remains unclear — some curious micro-lessons are emerging that deserve more debate.

Consider fixed-income exchange traded funds, which are financial instruments designed to track an underlying corporate bond index. Back in 2008, when worries centred on corporate credit defaults, regulators and investors tended to focus on banks. That was because big investment banks held vast inventories of corporate bonds and acted as market makers in this sector.

But the post-2008 reforms made it much more expensive for banks to act as market makers, so they sold down their inventories. Many of those holdings were bought by the ETF sector, which has exploded in size since then. “In mid-2007, broker-dealers held $418bn in corporate and foreign bond assets that could be used for market-making activity, but now these holdings account for less than $60bn,” notes Standard and Poor’s. In contrast, ETFs’ corporate bond holdings jumped by more than $500bn in that period.

This has generated good fees for ETF managers and made banks more robust. But it left policymakers worried about market liquidity, too. Market makers have an incentive to keep markets trading in a crisis. However, entities such as ETFs do not, since they essentially operate on autopilot, buying and selling bonds automatically to match an index. 

Thus, regulators have fretted that the change in ownership was creating market “fragility”. Even in good times “liquidity in corporate bond markets. appear[ed] less robust” than before, as a report from the Bank for International Settlements notes; in bad times, activity might freeze, it was feared.

So what actually happened in the Covid-19 market test? The Cassandras were partly right: in early March, the market for corporate bonds did indeed freeze. “Issuance in primary markets stopped, mutual funds saw sizeable outflows, and secondary market yield spreads to government securities widened very rapidly,” the BIS says. Ouch.

Worse, the ETF market went haywire — seemingly confirming the fears. Most notably, in early March, the price of ETFs collapsed so dramatically that the funds lost their link to the prices of the underlying corporate bonds. Some traded at a 5 per cent discount to the value of their underlying assets, in the most extreme moments of dislocation. 

That seemed utterly bizarre at the time. However, analysts have subsequently re-examined events with cool heads and two curious points emerge. These are that ETF price swings preceded other market moves, albeit in a more extreme way. Plus, this volatility did not occur because trading dried up; on the contrary, daily ETF trading volumes exploded, running 250 per cent higher than before the crisis, and investor redemptions were very modest in March compared with other asset classes. 

Thus, it seems that investors reacted to the corporate bond market freeze by using ETFs to hedge risks, conduct price discovery and dump exposures they disliked. ETFs were thus an investor crutch, not a market block.

Is this use of ETFs sustainable? Sadly, no one knows. On March 23, the Federal Reserve took dramatic action to halt the freeze in corporate credit, announcing big purchases of company bonds. It is possible that if that Fed rescue had not occurred, the funky ETF prices might have eventually caused those structures to fall apart. We will never know.

But investors need to ponder three points in the light of this saga. First, regulators are still grappling with all the unintended consequences of the post-2008 financial reforms. 

Second, since these reforms have changed market structures, it would be foolish to think that past models of liquidity provision are a good guide to the future. The March adventure around ETFs provided a benign surprise. But there are less cheering examples to ponder: in March the US Treasuries market also acted extremely strangely, because of hitherto-unrecognised hedge fund exposures. 

Third, as market structures change, central banks and regulators need to adapt. The BIS thinks the March events show that ETF “prices are more reactive to market developments than the prices of the underlying bonds are, especially at times of market stress”. Thus, it believes that ETF “prices are probably more suitable inputs to monitoring efforts and to risk management models, including those underpinning regulatory capital calculations, than relatively stale bond benchmarks”. 

That will not please anyone who fears that ETF managers are already far too influential for their own good. But the BIS assessment seems realistic. Or to put it another way, what the Covid-19 market shock has shown is that while the banks played a starring role in the last big financial crisis, non-bank financial structures, such as ETFs, matter much more now, and not just in the corporate bond world. That means ETFs deserve more scrutiny and debate — from politicians, as well as investors.

Free Exchange

Dollar dominance is as secure as American global leadership

The currency’s wobbles have fed fears that a reckoning looms for the world’s economic hegemon



It has been an ugly summer for America and the dollar. The greenback fell by more than 4% against a basket of other major currencies in July, the largest monthly decline in a decade, as the value of euros, gold and even bitcoin soared. In a year packed with extreme market movements, the dollar’s wobbles might seem unimpressive.

As they played out against a backdrop of American turmoil, though, they have fed fears that a reckoning looms for the world’s economic hegemon. An abysmal response to the pandemic, a stuttering economic recovery and soaring debt understandably contribute to concern about America’s economic wherewithal. But if there is reason to question the dollar’s dominance, it is not that America is becoming less economically mighty, but that the world order it built looks increasingly vulnerable.

Reserve-currency status is often cast as a matter of economic fundamentals. A reserve-currency issuer should play an outsize role in global trade, which encourages partners to draw up contracts in its currency. A historical role as a global creditor helps to expand use of the currency and encourage its accumulation in reserves. A history of monetary stability matters, too, as do deep and open financial markets.

America exhibits these attributes less than it used to. Its share of global output and trade has fallen, and today China is the world’s leading exporter. America long ago ceased to be a net creditor to the rest of the world—its net international investment position is deeply negative.

Soaring public debt and dysfunctional government sow doubt in corners of the financial world that the dollar is a smart long-run bet. And whispers, suggesting that the day of the dollar’s eclipse by the euro or the yuan looms, grow louder from time to time.


Debates about a changing of the guard are hampered by a dearth of historical comparisons.

The replacement of one currency by another as the modern world’s monetary bulwark has occurred precisely once—when the dollar overtook sterling. That makes identifying its critical causal factors nearly impossible. Economists once thought that network effects made reserve-currency status a winner-take-all affair.

It is more attractive to conduct trade or hold savings in a currency that is widely used by others, giving reserve currencies an edge over challengers. That America’s output overtook Britain’s as early as 1880, while the dollar did not clearly dominate until enshrined in the Bretton Woods economic institutions more than 60 years later, seemed to prove that dominant currencies are not easily dislodged. But accumulating evidence suggests a revision of these views may be warranted.

In practice, leading currencies often share a reserve role with others. Sterling ruled the roost before the first world war, but still accounted for no more than two-thirds of global currency reserves at the end of the 19th century (German marks and French francs made up most of the rest).

Furthermore, the dollar overtook sterling much earlier than once thought. By the early 1920s it already accounted for at least 50% of major economies’ foreign-currency reserves. Reserve-currency status may not be so unassailable after all.

Even so, challengers have for decades failed to knock the greenback from its perch. Part of the explanation is surely that America is not as weak relative to its rivals as often assumed. American politics are dysfunctional, but an often-fractious euro area and authoritarian China inspire still less confidence.

The euro’s members and China are saddled with their own debt problems and potential crisis points. The euro has faced several existential crises in its short life, and China’s financial system is far more closed and opaque than the rich-world norm.

Dollar dominance also reflects factors that conventional economic analyses sometimes omit: geopolitics. Sterling ruled during a long period of increasing global integration to which Britain—as a financial, industrial and military powerhouse—was central.

The first world war brought an end to that era, and sterling soon lost its position. It shared reserve-currency status with the dollar into the 1940s, but under very different circumstances than prevailed in pre-war times; global trade and cross-border investment did not return to the levels of 1913 until the final third of the 20th century.

It was not just American economic superiority that put the dollar at the centre of the post-war order, but its unrivalled geopolitical might as well, which it used to reforge an integrated global economy.

Work published by Barry Eichengreen of the University of California, Berkeley, and Arnaud Mehl and Livia Chitu of the European Central Bank highlights the role of power politics in currency choice.

Analysing reserve holdings before the first world war, the authors find that military alliances influenced the composition of reserves. A pact, they reckon, boosted a currency’s share in an ally’s reserve holdings by 30 percentage points.

Get the buck out of here

So the global role of the dollar does not depend on America’s export prowess and creditworthiness alone, but is bound up in the geopolitical order it has built. Its greatest threat is not the appeal of the euro or yuan, but America’s flagging commitment to the alliances and institutions that fostered peace and globalisation for more than 70 years.

Though still unlikely, a collapse in this order looks ever less far-fetched. Even before the pandemic, President Donald Trump’s economic nationalism had undercut openness and alienated allies. Covid-19 has further strained global co-operation.

The IMF thinks world trade could fall by 12% this year. Supply chains that sprawl across national borders may retreat amid concerns about economic conflict and national security. America and China seem to be sliding into a new cold war.

Though America’s economic role in the world has diminished a little, it is still exceptional. An American-led reconstruction of global trade could secure the dollar’s dominance for years to come.

A more fractious and hostile world, instead, could spell the end of the dollar’s privileged position—and of much else besides.

How Pimco’s Cayman-Based Hedge Fund Can Profit From the Fed’s Rescue

Congress said borrowers in taxpayer-backed rescue programs had to be from the United States. Wall Street has a workaround.

By Jeanna Smialek

The goal of the Fed’s program is to bolster a critical corner of U.S. debt markets, not to make money for investment vehicles and investors.
The goal of the Fed’s program is to bolster a critical corner of U.S. debt markets, not to make money for investment vehicles and investors.Credit...Pool photo by Tasos Katopodis


WASHINGTON — Pacific Investment Management Company runs a hedge fund registered in the Cayman Islands, a common structure for avoiding certain U.S. taxes. But when a profit opportunity arose from the ashes of America’s coronavirus crisis, that international location did not stop it from seizing the moment.

The Federal Reserve opened a highly anticipated emergency lending program in June, a revamped version of one it used during the 2008 financial crisis. This time around, Congress stipulated that only American companies can participate as borrowers in such programs. Despite being offshore, Pimco’s fund had an easy way to benefit.

The offshore fund is invested in an entity registered in Delaware. That entity can be used by investment managers to buy and sell bonds. The Delaware operation borrowed $13.1 million from the Fed program by pledging a bundle of debt as collateral. Investors in the Cayman-based hedge fund ultimately stand to profit from the transaction.

The Pimco example is not unique — other foreign investors have put money into U.S.-based funds that are tapping the Fed program. That they found a way to participate in a program restricted to American borrowers highlights the potential for financial firms to make money from the Fed’s market rescue programs, even if doing so means maneuvering around congressional limitations on eligibility.

Investors earned double-digit returns on the program during the 2008 financial crisis and they stand to profit this time around as well, as they collect interest on the debt bundles and, thanks to the Fed’s cheap funding, pay very little to hold them.

The Fed’s program is intended to keep credit flowing through the economy, but its design has provided an opportunity for global financial players to profit from an initiative backed by taxpayer funding. That side effect could draw further scrutiny to the Fed’s rescue efforts, which are already prompting questions from lawmakers about who benefits, and on what terms.

The lending programs “drag the Fed into political crossfire,” said Mark Spindel, chief investment officer at Potomac River Capital and an author of a book on the politics of the Fed. “The Fed is seen as the honest broker in town — but just because you’re the honest broker today, doesn’t mean you’re not going to face questions down the road.”

The goal of the Fed program in question, known as the Term Asset-Backed Securities Loan Facility or TALF, is to bolster a critical corner of U.S. debt markets, one where loans are bundled and sold off to investors who are willing to take on risk in exchange for interest payments. That helps to keep the market for commercial mortgages functioning, and allows student loans and credit card debt to continue flowing to end-users.

The program was not created to make money for investment vehicles or the investors they represent. But because of the way TALF works, financial firms like Pimco’s hedge fund can make a profit from it.
It operates by encouraging investors to purchase a certain type of debt called asset-backed securities.


The Newport Beach, Calif., offices of the Pacific Investment Management Company, which runs a hedge fund registered in the Cayman Islands.
The Newport Beach, Calif., offices of the Pacific Investment Management Company, which runs a hedge fund registered in the Cayman Islands.Credit...Mike Blake/Reuters


A fund can buy those securities using some combination of cash and short-term loans and then take them to the Fed in exchange for a TALF loan.

The TALF loan can be used to pay back whatever money the fund borrowed to make the purchase in the first place, so that its holdings are financed mostly by the cheap Fed loan, and a sliver of its own money (what is known as a “haircut” in financial parlance). It essentially earns the difference between what it makes in interest from the securities and what it is paying on the Fed loan.

Because investors have just a small amount of money at stake, returns on each invested dollar can be quite high. Investors said they anticipated high single-digit returns in 2020, far lower than the double-digit returns in 2008 but still generous.

The Fed has so far released detailed data only on TALF’s first round of loans, though the program has since finalized two more rounds. The Fed will most likely release additional data in mid-August.

Pimco’s Cayman Islands-based fund, which has borrowed via a U.S.-based entity called TOCU IX, is one of several foreign investors using an American investment vehicle to gain access to TALF.

The pension plan of the Oxford University Press Group will tap the program through a fund set up by the New York-based investment manager MacKay Shields. A Singapore-based fund is a material investor in an offering by the giant financial firm BlackRock, according to the Fed’s first round of detailed disclosures.

The fact that some investors based overseas can make money from TALF does not break Congress’s rules, but it may fall shy of what some lawmakers intended. They specified that loans, advances and asset purchases made under the Fed’s programs should be restricted to “businesses that are created or organized in the United States or under the laws of the United States.” But they said nothing about who could ultimately benefit.

“There are going to be people who focus on this like a laser,” Peter Conti-Brown, a Fed historian at the University of Pennsylvania’s Wharton School, said of the fact that foreign investors in some cases benefit from Fed programs. But the reality, he pointed out, is that financial markets are global.



“Others are going to say that there’s no way to provide liquidity without benefiting international counterparties.”

And while Pimco’s fund and other foreign investors may profit by participating in the program, their investment is also helping to keep more money flowing into the Fed’s program, smoothing over U.S. securitization markets.

That reality has presented a challenge for the Fed, which has had to walk a fine line between creating emergency programs that are effective while also making them politically palatable.

Lawmakers want the Fed to help the economy, but have also warned the central bank against allowing companies to take advantage of taxpayer-backed funding.

When Republicans and Democrats were hammering out the details of their coronavirus rescue package in March, congressional leaders agreed to give the Treasury Department $454 billion to back up Fed emergency programs.

The Fed requires a Treasury backstop for many of those efforts, to insure against losses in case borrowers default. But because the Fed did not expect to lose every dollar it lent out, it could use the $454 billion to field a huge rescue: potentially more than $4 trillion in loans to businesses, states and cities.

The ability to supersize the coronavirus response package was an attractive proposition. But many lawmakers in both parties were wary about handing the Fed and the Treasury so much money. Many remembered the 2008 bank bailouts and the bad taste they had left behind. They did not want a repeat.

Treasury Secretary Steve Mnuchin in the Capitol on Tuesday. Congressional leaders earlier agreed to give the Treasury Department $454 billion to back up Fed emergency programs.
Treasury Secretary Steve Mnuchin in the Capitol on Tuesday. Congressional leaders earlier agreed to give the Treasury Department $454 billion to back up Fed emergency programs.Credit...Anna Moneymaker for The New York Times


So Steven Mnuchin, the Treasury secretary, and key lawmakers agreed to terms that attached strings to the funding. Companies borrowing direct loans might be asked to try to maintain their payroll. Those who borrowed directly would also be banned from making dividend payments, and executives would face compensation limits. Only U.S. companies could borrow.

Those requirements are generally guidelines rather than binding rules, given the way the programs work. The Fed has found itself being hammered on both sides — some lawmakers have questioned whether the central bank is precluding companies from using its programs by being too strict, while others have warned it against letting big corporations and Wall Street firms benefit.

Foreign investor participation in the TALF program could raise similar questions from lawmakers and the oversight groups set up to police where the funds are going. Mr. Conti-Brown and others say that while Congress gave the Fed the room to make design choices, that will not insulate the central bank from critique.

The fact that the Fed has discretion “is a byproduct of political compromise,” Mr. Conti-Brown said. But “the Fed is always open to criticism down the road.”


Jeanna Smialek writes about the Federal Reserve and the economy. She previously covered economics at Bloomberg News, where she also wrote feature stories for Businessweek magazine.

School Choice Is the Only Option

If there is a potential silver lining to the United States' experience with COVID-19, it can be found in the domain of primary and secondary education, where the demand for alternatives to traditional public schools is surging. The pandemic has both laid bare the US education gap and pointed the way to a solution.

John B. Taylor

taylor10_FREDERIC J. BROWNAFP via Getty Images_schoolcoronavirussocialdistance


STANFORD – After years of rumblings for change in US education, the COVID-19 pandemic is becoming a catalyst for improving the system. America’s educational divide – especially in grades K-12 (elementary through high school) – is now clearly visible for anyone to see.

Disparities in quality and access to education are a major source of the economic, social, and racial inequalities that are driving so much social unrest from Austin and Oakland to Portland and Seattle. Whether they come from impoverished inner-city neighborhoods or the suburbs, the least-educated Americans have been the hardest hit by the pandemic and its economic effects.

From Latin America’s lost decade in the 1980s to the more recent Greek crisis, there are plenty of painful reminders of what happens when countries cannot service their debts. A global debt crisis today would likely push millions of people into unemployment and fuel instability and violence around the world.

Fortunately, economist Thomas Sowell (my colleague at the Hoover Institution) has offered a solution. In his new book, Charter Schools and Their Enemies, he shows that schools with more autonomy and flexibility than traditional public schools are closing the educational divide, providing sorely needed choice, opportunity, and competition.

Sowell’s careful analysis of the data, which was available before the pandemic struck, shows that students in publicly funded but privately operated charter schools like Success Academy in New York City score remarkably higher on standardized achievement tests than do those in traditional public schools. The book contains reams of convincing evidence, all of which is explained beautifully and presented clearly in more than 90 pages of tables.

Sowell controls for many factors, including school location: students at charter schools within the same building as a traditional public school perform several times better on the same tests.

And he supplements the hard data with simple evidence, such as the long waiting lists to get into the better performing charter schools. But if charter schools work so well, what explains the enemies mentioned in the book’s title? Critics of charter schools would list many reasons, but the main one, Sowell laments, is that public schools simply do not want the competition.

Will the COVID-19 crisis finally change things? There are already positive signs that it has.

Last month, US Secretary of Education Betsy DeVos unveiled a new, five-year $85 million scholarship fund that will help students from lower-income families in Washington, DC go to schools of their choice. It is part of her department’s Opportunity Scholarship Program, the only federally funded school-choice initiative in the United States.

The average income of families in the program is less than $27,000 per year, and more than 90% of students in it are African-American or Hispanic/Latino.

In another promising sign, US Senators Tim Scott of South Carolina and Lamar Alexander of Tennessee recently introduced a bill to direct some of the educational relief funding in this year’s US Coronavirus Aid, Relief, and Economic Security (CARES) Act to school-choice programs.

That money would enable lower-income families that are hard-pressed by the pandemic to send their children to alternative schools. Among other things, the legislation would direct 10% of CARES Act educational funds toward scholarships for private-school tuition or reimbursement for homeschooling costs.

But most telling, perhaps, is the fact that many families and individuals are coming up with their own solutions. Consider the sudden blossoming of pandemic learning “pods,” wherein parents get together, find teachers, and form a class for kids in the neighborhood.

Learning pods are a natural civil-society response to school closing in many districts in California and elsewhere. When schools suspend services, parents immediately will seek out alternative solutions, especially when they have concerns about their children’s ability to learn remotely.

Of course, learning pods already have enemies of their own, with critics complaining that the practice is unfair, harmful for traditional schools, or available only to those who can afford to hire teachers. But that is all the more reason to make high-quality, effective schools more widely accessible. Quashing new ideas is not the answer.

The struggle over pandemic-era education is quickly moving to statehouses. In June, as part of the new state budget, California lawmakers passed Senate Bill 98, which caps per-student state funding for charter and public schools at last year’s funding levels. The point is to limit charter school enrollments at a time when demand for alternatives to traditional public schools is surging. But with those public schools closing and resorting to remote teaching, students from lower-income households will be the ultimate victims.

There are already at least 13,000 students waiting to enroll in charter schools in California. But owing to SB98, notes State Senator Melissa Melendez, “if you are in a school that is failing that is really too bad. You are just going to have to stay there and deal with it. That is not fair to the student or the parent.”

In his book, Sowell points out that, “Those who want to see quality education remain available to low-income minority neighborhoods must raise the question, again and again, when various policies and practices are proposed: ‘How is this going to affect the education of children?’”

If we all focus squarely on that question, the pandemic’s long-term impact on education could turn out to be highly beneficial.


John B. Taylor, Under Secretary of the US Treasury from 2001 to 2005, is Professor of Economics at Stanford University and a senior fellow at the Hoover Institution. He is the author of Global Financial Warriors and (with George P. Shultz) Choose Economic Freedom.