South Korean regulators tightened rules on tracking gaps for single-stock leveraged exchange-traded funds tied to Samsung Electronics and SK hynix, but 86 disclosures of such gaps were filed in the four days that followed. None of the products exceeded the tighter obligations imposed on liquidity providers.
A total of 86 disclosures of ETF tracking gaps were filed between the 19th of this month, when the tighter standards took effect, and the 25th, according to the Korea Exchange. Disclosure is required when the gap exceeds 1% for ETFs tracking domestic assets and 2% for those tracking overseas assets. The products that triggered disclosures stayed within the liquidity provider management thresholds of 2% for domestic assets and 5% for overseas assets.
An ETF tracking gap is the difference between the price at which an ETF trades in the market and its net asset value, which reflects the underlying worth of the assets it holds. A wider gap raises the risk that investors buy an ETF above its actual value or sell it below.
Regulators tightened the closing-price tracking gap obligations for liquidity providers effective the 19th of this month, after the launch of single-stock leveraged ETFs increased market volatility and price distortions recurred in some products. The management threshold for ETFs based on domestic assets was lowered to 2% from 3%, and for those based on overseas assets to 5% from 6%.
Liquidity providers post bid and ask quotes in ETF trading to narrow the gap between market prices and net asset value. The exchange evaluates them each quarter based on fulfillment of obligations, which accounts for 40% of the score, along with proactiveness at 20%, average spread at 20% and average quote volume at 20%.
The concern is that gaps have continued to exceed disclosure levels even after the tighter standards took effect, raising questions about liquidity providers' ability to manage quotes. When markets swing sharply or orders concentrate in a particular ETF, liquidity providers may fail to supply appropriate quotes in time, widening the gap between market prices and net asset value.
In the second-quarter evaluation of ETF liquidity providers, 19 of 26 firms received a C grade. That share, at 73.1%, topped 70% for the first time since the assessments began. Only one firm received an A grade and six received a B. In the first quarter, one firm was graded A, 18 were graded B and seven were graded C, putting the C share at just 26.9%.
Industry officials say a C grade carries little practical penalty, leaving liquidity providers with weak incentives to improve their management capabilities. Rather than simply lowering the tracking gap thresholds, they say, authorities should make oversight more effective by linking evaluation results to the allocation of liquidity provision mandates or eligibility to participate in new products.
