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With that backdrop, let's set the stage: a $1 trillion ETF market built on illiquid securities with 3 big banks as the primary gatekeepers exhibits a credit shock. What happens?
APs are unable to profit from arbitrage - the underlying bonds of an ETF cease to trade freely, meaning the banks can't create or redeem new shares. The primary market freezes, but the secondary ETF market keeps trading. Illiquidity discounts begin to form in the ETF.
We saw this exact dynamic happen in March 2020 - near the bottom, some large fixed income ETFs were trading at 5%+ discounts to the value of their underlying assets. Fears of a "liquidity doom loop" began to emerge… Until the Fed saved the day.
I tell this story to point out that, like past unstable financial products, ETFs are reliant on "selective liquidity" from banks to function. When banks decline to support the market, the Fed has to step with greater speed & size to keep the peace. FIN
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