People are worried about bond market liquidityWe have talked a lot around here, over many years, about bond market liquidity and bond exchange-traded funds. People were worried about bond market liquidity, and they were worried that bond ETFs were somehow bad for it. For instance, last March, there was a lot of stress in the bond market, and some bond ETFs traded at discounts to their net asset value, and we talked a lot about that. I sort of thought we were out of things to say about bond market liquidity. But the March BIS Quarterly Review from the Bank for International Settlements has a cool special feature by Karamfil Todorov on "The anatomy of bond ETF arbitrage" that actually has something new and interesting to say about bond ETFs and bond market liquidity. The way an S&P 500 exchange-traded fund works is roughly that the fund holds a big pile of all the 500ish S&P 500 stocks, and if anyone wants to buy or sell shares of the ETF they can trade with each other on the stock exchange. Sometimes people want to buy more shares than are for sale on the exchange, and so they will want to buy new shares from the ETF itself. But you can't really buy new shares in the ETF, like you could in a mutual fund (you give the fund cash, it buys the underlying stocks, it gives you back shares). Instead there is a "creation" mechanism: There are firms called "authorized participants" (big broker-dealers and market makers) who go out and buy the underlying stocks and deliver them to the ETF in exchange for new shares of the ETF. An authorized participant will buy $10 million of S&P 500 stocks, hand them to the ETF, and get back $10 million of ETF shares. Similarly sometimes a lot of people will want to sell ETF shares, and an authorized participant will do a redemption trade in which it hands ETF shares back to the ETF and gets, not cash, but a basket of underlying stocks. (Which it can then sell for cash.) This creation/redemption mechanism—in which the ETF doesn't buy or sell the underlying shares itself, but does in-kind trades with authorized participants—is good for the ETF's expense efficiency (it doesn't explicitly pay to trade) and for its tax efficiency (it doesn't realize taxable gains). It is also good for the ETF's pricing accuracy: If the ETF trades at a premium to the underlying stocks, there is an obvious arbitrage (buy the stocks, deliver them to the ETF for creation, get back ETF shares and sell them at a premium), which should keep the ETF's price in line with the underlying index. This is basic obvious stuff, but it isn't really true for bond ETFs. For an S&P 500 ETF you can go buy all the S&P 500 stocks fairly efficiently and electronically, but for a 500-bond ETF it would be very difficult to go buy 500 bonds. The BIS explains: Whereas for equity ETFs baskets are usually almost identical to holdings, for bond ETFs they are systematically different and include a small share of the bonds in the actual holdings, eg less than 3% for the largest bond ETF. For bond ETFs, baskets also change significantly from day to day and creation baskets tend to have longer duration and higher liquidity than redemption baskets. Several factors are behind this contrast between equity and bond ETFs. First, the nature of the underlying assets is different. Compared with equities, bonds are generally less liquid and trade in a market with fewer potential buyers and sellers. In addition, bonds mature, whereas equities do not. Second, the minimum trading amount of bonds is much larger than that of equities, which constrains the feasible trades. Given these specificities of the bond market, ETF sponsors need flexibility as regards the composition of baskets. Sponsors choose strategically which bonds to include among the available ones, with an eye on continuously matching key characteristics of the benchmark index. Likewise, APs influence the composition of baskets and could use them to accommodate demand from their own clients rather than to close arbitrage gaps.
There are three points here. One is that it is not, like, a structural requirement of ETFs that the creation and redemption baskets be a perfect sample of the underlying ETF: You could in theory do a creation trade with an S&P 500 ETF in which you give the ETF $10 million of only Tesla Inc. stock and get back $10 million of ETF shares, and in fact sometimes stock ETFs do handle index additions and removals that way. With bond ETFs that is just the normal approach: You could never give the bond ETF all the bonds, so any creation or redemption trade will involve some skewed sample. The second point is that the ETF sponsor—the ETF itself—will want the creation and redemption baskets to be good for the ETF. So, for instance, it will want to get rid of short-maturity bonds (to avoid having them mature and having to reinvest the cash) and add longer-maturity bonds, so the creation basket will be longer-dated than the redemption baskets. It will ask its authorized participants to bring it the bonds it wants to create shares, and to take away the bonds it doesn't want to redeem shares. The third point is that the authorized participants will want the creation and redemption baskets to be good for them. Many APs are big banks and market makers who want to do portfolio trades for customers. A customer will come to a bank and say "I have these 30 bonds that I want to sell, how much will you pay for them?" And the bank will say "well I would pay a lot for them if I could just squeeze them into an ETF, get back ETF shares, and sell the ETF shares quickly on a liquid stock exchange." So the bank will pick the most relevant bond ETF—if the customer has junk bonds, it will pick a junk-bond ETF, etc.—and call up the ETF and ask "hey would you take these 30 bonds as a creation basket?" And the ETF will look at the list and say "ahh that's close enough to our index, sure, wave it in." And a trade will get done. The BIS writes: ETF sponsors' portfolio optimisation and their incentives to maintain a long-term relationship with APs can lead to differences between baskets and holdings and to changes in baskets over time. Sponsors would adapt the composition of baskets based on the availability of bonds and would choose a subset of bonds that minimises tracking error. In turn, when an AP cannot deliver a bond ... it could propose some similar new bond ... that is easier to locate for the transaction and could even allow the AP to absorb a supply shock from its clients. While this bond is not part of the ETF holdings, a sponsor might accept the proposal if the new bond keeps the tracking error in check and helps maintain the relationship with the AP, whose market-making function provides valuable services to the sponsor.
There is a negotiation: The ETF wants a certain basket, the APs want a different basket, and they work together to get a basket they can both live with. Here's what this has to do with bond market liquidity. People worry about bond ETFs creating a "liquidity illusion": You can trade bond ETFs easily on the exchange, which makes you think they are more liquid than they are, but if everyone wants to redeem at once then there will be forced selling of the underlying bonds and a horrible death spiral. With regular mutual funds, there is some basis for this worry. If everyone wants to redeem out of a bond mutual fund, they will all go to the mutual fund and ask for their money back. The mutual fund will have to sell bonds to raise money to give back to them. It will sell its most liquid bonds first, because they are easier to sell quickly to raise money. This will tend to leave the mutual fund with worse, less liquid bonds. Other investors will see this, realize that the mutual fund is getting worse, and also demand their money back. The fund will have to sell less liquid bonds, at a bigger discount, driving down its asset value and leading to more redemptions, etc. With ETFs, though, the mechanism is different, perhaps even the opposite. If everyone wants to redeem out of a bond ETF, they will sell shares to an authorized participant, who will hand them back to the ETF sponsor. The ETF sponsor will hand the authorized participant back a chunk of its bonds. But it will hand them the worst bonds, the illiquid ones that it would have trouble selling, and keep the liquid ones for itself. From the BIS: By selecting the composition of baskets, ETF sponsors could discourage runs by influencing the desirability of redemptions (Shim and Todorov (2021b)). If there is excessive selling of ETF shares in the secondary market, which puts redemption pressure on APs, the ETF sponsor can include only the riskier or less liquid securities from the pool of holdings in the redemption basket. The lower-quality bonds that APs obtain after redeeming ETF shares would in turn reassure non-running investors that their shares are now backed with holdings of higher average quality. This would discourage further runs and lead to ETF discounts during run episodes. In fact, such a stabilisation mechanism was arguably in place during the March–April 2020 episode … when some ETFs traded at a discount while redeeming baskets that were more illiquid than the holdings.
That is, according to the BIS, the reason that bond ETFs traded at a discount to the underlying bonds during last spring's bond crash really is that the ETF arbitrage mechanism broke down, but in a good way, in an intended way, in a way that makes bond ETFs more robust and less prone to runs. In times of stress, bond ETFs will trade below net asset value, but the redemption mechanism means that you kind of can't get your money back, or not efficiently, so you don't redeem (that is, authorized participants don't redeem to arbitrage away the discount), so there is no run on the ETF, so there is no need for it (or its authorized participants) to dump bonds at fire-sale prices, so there is no broader collapse in bond prices and no contagion. The ETF trades below its net asset value because it is, in effect, absorbing stress on the bond market, rather than transmitting it. Private secondary marketsMy basic view of private investments—stocks that are not traded on the stock exchange but are instead limited to accredited investors who meet some wealth requirement—is that the good private investments get offered to the good private investors, and the bad private investments get offered to the bad private investors. If you are a brand-name venture capitalist, the best startups will compete to get you as an investor, and you'll have plenty of opportunity to do due diligence and negotiate terms. If you're a dentist, you will be offered a steady stream of nonsense private real-estate investments by shady brokers who charge large fees. Proposals to democratize private investments—to loosen the "accredited investor" definition to allow more people to invest in startups—often don't sufficiently account for this difference. Public stock markets are open to everyone; if you want to buy Apple Inc. shares, you can get them for the same price as Warren Buffett pays. Private companies get to pick who they sell shares to, and small-time private investors won't get the same opportunities as big-time ones. Private secondary markets might be a little better though? The hottest startups are always going to be able to choose who they sell shares to, but then those people might want to resell their shares in the secondary market. (Assuming that's allowed under the terms of their investment—which sometimes it is, sometimes it isn't.) "The secondary market" could mean one big VC firm selling its startup shares to another (or to SoftBank) in a negotiated transaction, but it could also mean some sort of anonymous electronic market where private investors can sell private stock to the highest bidder. In other words, it could look like the public market, only limited to accredited investors. Hot startups might want their shares to be listed on private exchanges like this, and investors might want to sell on those exchanges, because they might offer the best liquidity, and startups might want view it as part of their job to provide liquidity for their early investors and employees. And then if you are a dentist you can buy the same shares in hot startups as the best venture capitalists. I mean, not really—the really early-stage startups and the really favorable deals will still go to brand-name investors—but at least if you want to compete with growth-capital funds and mutual funds to pay a lot for shares of big unicorns, you can do that. Anyway here's a Financial Times "Big Read" on private secondary markets: Until recently, private secondary markets resembled "that guy with a trenchcoat that's selling you watches in Times Square", says Inderpal Singh, who leads a private secondary market project at the start-up marketplace AngelList. "In the last year, there's been a big shift." In addition to AngelList, JPMorgan and the software start-up Carta have begun facilitating trades in private companies. They compete with established players like Nasdaq and Forge Global, which purchased the rival marketplace SharesPost in a $160m deal last year, as well as scores of smaller independent brokers. Carta and some other intermediaries have advocated that the SEC relax restrictions on who can purchase shares in private companies, potentially opening up the market to a broader swath of investors. ... The rush to expand trading could lead to fraud and manipulation, says Stephen Diamond, a professor of law at Santa Clara University who has studied private secondary transactions. "All too often in Silicon Valley, people want to basically ignore the consequences of unhealthy market structures," Diamond says.
I'm not especially convinced that trading shares of big unicorns on private secondary markets is all that much worse than trading shares of special purpose acquisition companies on public markets. People want to overpay for startups without knowing much about them! They are going to find ways to do it. Walmart fintechI don't know, if you had asked me 10 years ago, "which big company will get into retail banking first, Goldman Sachs Group Inc. or Walmart Inc.," I guess I would have said Walmart? Or if you had said to me "I would like you to start a retail bank within a giant company, would you prefer the company to be Goldman or Walmart," again Walmart seems like the correct answer?[1] Like, Walmart has high-traffic physical branches everywhere, it has lots of retail brand recognition and loyalty, it has millions of retail customers who probably could use access to credit and savings and transactions products, it has lots of data on them, there are very natural pitches like "open a credit card now to buy this thing" or "I see you are cashing checks at Walmart, would you like to open a checking account?" How hard can it be to do a bank? You've got the customers and the distribution and the uses for the product, all you need is to do the technical and regulatory work of setting it up. Goldman … not so much? Actually 10 years ago I still worked at Goldman myself (disclosure!). It already had a bank holding company charter and ran a small bank, and one would occasionally joke with investment banking clients about giving them a toaster when they did a merger, but there was not exactly a retail feel to the place. Sure yes Goldman had the technical ability to flip a switch and offer banking products—it had a bank charter—but other than that, there were no branches, no retail customers, no natural use for a Goldman checking account. Since then Goldman has put a lot of effort and attention into its retail product, which is called "Marcus" after Marcus Goldman's first name; it has lending and savings accounts and a credit card with Apple Inc. It has all gone better than I would have guessed a decade ago. Disclosure, I am a customer. Still. I have seen no evidence that Walmart is going to call its retail banking product "Sam," but maybe it should? Anyway: Walmart Inc. has lured a pair of senior Goldman Sachs bankers to help lead a new fintech startup as the retail giant muscles into the banking business. Omer Ismail, the head of Goldman's consumer bank, is making a surprise exit to the fintech, according to people with knowledge of the matter. The world's largest retailer made a splash last month after disclosing plans to offer financial services with an independent venture in a tie-up with investment firm Ribbit Capital without offering much detail. David Stark, one of his top lieutenants at Goldman, will join him in the new venture, the people said, asking not to be identified as the moves haven't been announced. ... Walmart's move -- depriving one of Wall Street's elite firms of the talent atop its own foray into online banking -- underscores the seriousness of the retailer's intent to intertwine itself in the financial lives of its customers. The audacious poaching punctuates years of warnings by bank leaders that their industry faces tough new challengers, after regulators smoothed the way for corporate giants and Silicon Valley to expand into payments and other services.
Yeah, I mean, how hard can it be to do a bank? You hire two guys who did it at Goldman, you do some lobbying to get some favorable regulations, you figure out a product, you roll it out to your millions of customers. Meanwhile Goldman is not going to open a lot of stores across America anytime soon. Boring BuffettThe consensus seems to be that Warren Buffett's annual letter to Berkshire Hathaway Inc. shareholders was pretty boring? "Anyone looking to hear his thoughts on today's issues may feel let down," writes my colleague Tara Lachapelle; "he didn't directly address any of them." "Buffett's 'Tone Deaf' Annual Letter Skirts Major Controversies," says the Bloomberg News headline. The letter is a lot of, like, "insurance float is good" and "Apple Inc. is a good company"; it's largely stuff we already knew. It is boring in a soothing way though. For instance, Buffett didn't really spend much money on big acquisitions last year, so he can't point to anything that he did to grow Berkshire's pile of assets. But he can point out that he grew each shareholder's share of that pile: Last year we demonstrated our enthusiasm for Berkshire's spread of properties by repurchasing the equivalent of 80,998 "A" shares, spending $24.7 billion in the process. That action increased your ownership in all of Berkshire's businesses by 5.2% without requiring you to so much as touch your wallet. … The math of repurchases grinds away slowly, but can be powerful over time. The process offers a simple way for investors to own an ever-expanding portion of exceptional businesses. And as a sultry Mae West assured us: "Too much of a good thing can be . . . wonderful."
It is not his aptest sultry quote. If you own Berkshire Hathaway stock, what you are hoping for is for Warren Buffett to go out and find new exceptional businesses and acquire them at a discount to their true value. You get an ever-expanding portion of exceptional businesses because Buffett uses his huge pile of cash to acquire an expanding list of exceptional businesses. "The exceptional businesses are the same as last year but now you own a slightly higher share of them": Perfectly fine! Reasonable use of cash, if you can't find new exceptional businesses! Better than overpaying for bad businesses, etc. Just kind of uninspiring. Too much of this particular good thing is obviously bad; if Berkshire announced "we're done building the company and are just gonna buy back stock" no one would be happy about it. Free GameStop!When you sign up for Robinhood Markets, the free-stock-trading-on-your-phone app, they give you some free stock to get you started. Usually it's about $5 worth, some fraction of a share of some random company, to get you excited about trading stocks all day on your phone, to make it all feel a bit more like a fun casino. "Shares of free stock are chosen randomly from our inventory of settled shares," it says. Mostly you get, like, Amalgamated Ball Bearings Ltd., and you shrug and sell it. Sometimes, though, the roulette ball lands on GameStop. Here is a hilarious Bloomberg News article about people who signed up for Robinhood, got shares of GameStop Corp. stock, and then either (1) forgot about it until GameStop went almost to $500 for no particular reason earlier this year, at which point they were up hundreds of dollars and had a funny story, or (2) promptly sold it and regretted it when GameStop went almost to $500 for no particular reason earlier this year, at which point they had missed out on hundreds of dollars of gains and had a funny story. Here's the good outcome: Cleo Romain, 23, ... didn't even realize she owned GameStop until recently. She received it for free after signing up for Robinhood in March. Romain, who was already investing through Fidelity, created an account but didn't end up using it. She almost forgot that there was anything sitting in her account. Romain didn't think to check in until last month, when the GameStop frenzy was in full tilt. When she logged in, she was stunned to see that the stock she received when it was at about $4 was now worth $373, a gain of more than 9,000%. "I was kind of keeping up with the news around that time, even before I knew I had the stock, I was interested and then when I logged in, I was like oh my gosh I actually have this," Romain said. "I mean, I invested $0 into it."
Yes she made a gain of, uh, infinity percent? She bought GameStop at zero and sold it at … wait, what, "Romain decided not to sell and still holds the stock," that's disappointing. Diamond hands I guess. Meanwhile here's the bizarrely bad outcome: The month Nathan Greninger received stock in GameStop Corp. for free from Robinhood Markets, the shares were trading at about $3.70 each. … Greninger, 21, didn't think twice before selling it in June for $4.95. Little did he know then that GameStop would soar to stratospheric heights above $400 by the end of January. While the shares have retreated from those lofty levels, they are still trading at more than $100. "Wish I would've held onto that now," Greninger said. "I could've used the extra money." ... For Greninger, who works in a retirement community in Tulsa, Oklahoma, regret led to even more pain. When the global mania over GameStop was at its peak last month, he says he couldn't ignore it. He bought the stock again when it was around $380 — and lost $280 on that trade when it slid back. "The hype and emotion behind it got to me, and I thought I'd make a quick buck," Greninger said. "I was investing money I shouldn't have. I've been trying to look at that as paying for my first lesson in investing, but it's hard not to just think about the money I lost."
He paid zero dollars for a stock that went on to go up by 13,000% over the course of a year, and somehow managed to bungle that into losing money. On the one hand buying at zero, selling at $4.95, buying again at $380 and selling again at $100 is sort of an all-time bad trade. On the other hand he seems to have executed this awful strategy on … one share of stock? Like he is out hundreds of dollars, has learned a valuable lesson, and has a funny story. Every bad story I read about GameStop has this basic form: People made some very bad trading decisions that led to rapid losses that were large in percentage terms, but it was with their fun gambling money, they learned a valuable lesson and they have a funny story. Seems fine. In other Robinhood news, "Robinhood to Plan Confidential IPO Filing as Soon as March." And: "Robinhood is facing 49 — that's right, 49 — lawsuits over Gamestonks." Things happenFraser Rises to Citi CEO Surrounded by Challenges and Deadlines. Jane Fraser Is Hitting Refresh at Citigroup. Anyone Who's Anyone Has a SPAC Right Now. Texas Power Firm Hit With $2.1 Billion Bill Files for Bankruptcy. Goldman CEO Warns Remote Work Is Aberration, Not the New Normal. Wall Street Is Set to Learn How Tough Biden's Watchdogs Will Be. Deutsche Bank under pressure over derivatives sales in Spain. SoftBank Settles WeWork Lawsuit; Neumann Exits With Windfall. McKinsey's Leadership Vote Reveals Cracks in Its Global Partnership. SEC Suspends Trading in 15 Stocks That Got Hyped on Social Media. How a 10-second video clip sold for $6.6 million. Shareholders push SEC for tougher climate regime for US oil. Credit Suisse Looks to Reduce Ties to SoftBank-Backed Greensill Capital. A SPAC Fuels the Takeoff of Electric Air Taxis. "'Pulling out your hair is an option, though only if you have hair to spare,' the mostly bald Singer wrote." "Unfortunately, we will not be able to proceed because of archaic big insurance companies that cannot adapt to innovative new ideas." "And he sat me down and he said: We are going to start using this thing called Gmail. I'm going to send you an invite, and you're going to set up firstname.lastname@gmail.com, no numbers, no nonsense, nothing else, you're going to have no signature, and you're only ever going to send text emails for the rest of your life. That's step one." "As for me, I like the film." If you'd like to get Money Stuff in handy email form, right in your inbox, please subscribe at this link. Or you can subscribe to Money Stuff and other great Bloomberg newsletters here. Thanks! [1] To be clear, Walmart is the *correct* answer, but *I* would have answered Goldman to that one, because I would have enjoyed the intellectual exercise of stuffing horrible derivatives into retail products. That is just one of many reasons why Goldman never asked me to open a retail bank. | 
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