Does the Diversity and Solvency of Authorized Participants Matter for Bond ETF Arbitrage? Evidence from the Dash for Cash Episode

Abstract

Authorized participants’ (APs) arbitrage in primary markets for ETF shares plays a key role in limiting dislocation in ETF prices. This paper builds a novel dataset of detailed US bond ETF-AP relationships and shows that high AP leverage played a significant role in weakening this arbitrage during the dash-for-cash episode of March 2020. The strength of the arbitrage relationship linking price signals to primary market activity weakened by 77 percent in ETFs related to more leveraged APs versus 64 percent for ETFs linked to less leveraged APs. This effect was particularly strong among those ETFs focusing on less liquid asset classes, relying on APs engaging in high-frequency trading strategies, and unrelated to banks and bank holding companies. Policy announcements by the Federal Reserve did not have had a strong impact in restoring arbitrage strength. AP leverage constraints operated in parallel to constraints faced by lead-market makers in secondary ETF markets, which were more closely related to regulatory capital limits.