The ETF liquidity problem - this is big and getting bigger

The power of the ETF market is its ability to provide immediacy for investors. You can transact like a stock and trade every day. Liquidity is as good or better than a mutual fund and the fees can be low. However, there is a problem if the immediacy of the ETF is greater or expected to be greater than the underlying assets that constitute the ETF. This is a massive liquidity problem waiting to happen. No, it is a liquidity problem that has already happened and may only get worse. 

The first chart from Citibank shows the size of mutual fund and ETF assets relative to dealer inventory. Dealers are supposed provide liquidity to the market, but that is not likely if they do not have the ability to warehouse securities in size. There is no way market-makers will be able to support outflows. The second graph shows how large mutual funds are relative to other investor types. They are more important than households and match insurance company assets. 

The second set of charts from the BIS shows the money that has flowed into bond funds. Previously, bond were held by investors who were more likely to house until maturity. That is not the case for bond funds. These funds offer daily liquidity, but there are unlikely to be enough immediate buyers if there are large bond fund sellers. The only way prices can remain steady is if the outflows are matched by inflows at the same time. This likelihood is slim. The result of less liquidity will be higher volatility and jumps in prices. We have not yet seen the impact of these types of liquidity events because so much has been inflows from investors searching for yield. If the direction of flows changes, there will be a liquidity problem. 

How do we know this will be a big problem? Look at the behavior of some ETF's on Monday morning. No liquidity on the open made for price declines of well over 30%. The prices were more reflective of fair value at the end of the day, but for those who wanted to transact early in the session, it was a disaster. The prices reflected "fair" value when there are no buyers. Investors should be worried because marketing material does not discuss this problem.  All traders should be worried because markets will not reflect reality. There will be a new reality of return jumps.