Bond Market Sell-Off Causes Stress in $2 Trillion ETF industry

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A wave of selling caused many exchange traded funds to tumble below the value of their underlying assets as a bond market sell-off caused stress in the $2 trillion ETF industry.

ETFs track baskets of underlying assets, such as emerging-market stocks or municipal bonds, but discounts widened sharply on Thursday as dealers struggled to keep up with the sell orders.

Emerging-markets ETFs were among the worst affected, as investors took fright that the end of Federal Reserve monetary easing would lead to outflows from developing countries.

(Read More: Bears Return to Emerging-Market ETF)

For example, the share price of the iShares MSCI Emerging Markets Index fell to a 6.5 per cent discount to the underlying asset value.

The selling also caused disruptions in the plumbing behind several ETFs. Citigroup stopped accepting orders to redeem underlying assets from ETF issuers, after one trading desk reached its allocated risk limits.

One Citi trader emailed other market participants to say: "We are unable to take any more redemptions today . . . a very rare occurrence due to capital requirements we are maxed out on the amount of collateral we have out."

A person familiar with the situation said it was a temporary suspension affecting only some clients, caused by the significant amount of sell orders. Citi declined to comment.

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State Street said it would stop accepting cash redemption orders for municipal bond products from dealers.

Tim Coyne, global head of ETF capital markets at State Street, said his company had contacted participants "to say we were not going to do any cash redemptions today". But he added that redemptions "in kind" were still taking place.

Market participants described the heavy volumes and losses on Thursday as a rare occurrence and said that it could translate into further selling on Friday or early next week.

"The losses for ETFs today were far beyond what the most sophisticated financial risk models could have predicated for worst-case scenarios," said Bryce James, president of Smart Portfolio, which provides ETF asset allocation models.

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He added: "The falls violated risk tolerance levels for many investors and if they were leveraged at all they are likely facing capital calls."

ETFs have been a boom product in recent years. They are bought and sold as an equity but can hold a variety of assets that are less liquid than exchange traded stocks.

The heavy selling across global markets triggered the disruption in products that track less liquid assets such as municipals or securities in markets that are closed during parts of the US trading day.