Liquidity is important – it refers to the ease with which you can buy and sell an investment. The variable liquidity in equity markets is driven by basic supply and demand constraints. This is unavoidable with equities, particularly for small caps with a small number of shares on issue. You can’t create liquidity if shares are tightly held and nobody wants to buy or sell.
Professional investors use the term liquidity in a broader sense. Liquidity is a measure of whether they can trade in the market without having a significant impact on the market price. The more liquid a market is, the greater the volume that can be transacted in a specific share without it impacting the price in a significant way.
Although XTBs are traded on the ASX, the ability to buy and sell is facilitated by a Market Maker. Therefore, their liquidity is not dependent on the number of buyers and sellers available.
What is a Market Maker?
A Market Maker is generally a bank or other financial institution that ensures investors and traders can always price and trade specific listed investment products by always being available to buy or sell those products.
The investment products that use Market Makers to create a liquid market are:
- Exchange traded funds (ETFs)
- Exchange traded products (ETPs)
- Warrants and options.
Each of these products has two key features in common that allow the ASX to adopt a Market Making model:
- .Each is based on a broader underlying market that has its own supply and demand dynamics. This market may provide liquidity for the Market Makers to access.
Example: The underlying market for XTBs is the corporate bond market.
- The products all have ‘open-ended’ structures. Rather than having a fixed number of securities on issue, they’re set up in such a way that new securities can be created and redeemed continually as new demand emerges. Market Maker can access the underlying market’s liquidity.
Example: NAB could have 100,000 XTBs on issue one day and 5,000,000 the next; trading in NAB shares is limited to the number of shares on issue, and the number that other investors are willing to buy or sell.
How does Market Making provide liquidity?
There are two Market Makers for XTBs on ASX – Deutsche Bank and Challis Investment Partners. Both have committed to the ASX Marketing Maker’s obligations, which includes an obligation to provide a ‘reasonable bid’ – or in other words, stand in the market and buy XTBs on ASX, for at least 80% of the trading day.
XTBs are based on an underlying market (the corporate bond market) and are an open-ended structure; this means the apparent liquidity on the ASX screen and the historic average daily value of XTBs are far less relevant to actual liquidity available compared to:
- The liquidity the Market Maker(s) can access in the underlying market
- How quickly the Market Maker(s) can convert this underlying liquidity into on-screen liquidity in XTBs on ASX.
While liquidity can be constrained for equities because you cannot create new shares out of thin air, the opposite is true of XTBs. The Market Maker can create new securities at any time provided it can access the underlying bonds.
The Market Maker can create new XTBs at any time during the trading day. The process is as follows:
- The Market Maker buys the relevant bonds
- The Market Maker puts the bond into the Australian Corporate Bond Trust (the Trust). This holds the bonds on behalf of XTB investors
- The Trust issues XTBs to the Market Maker in return, and is the vehicle that is quoted on ASX.
As long as there are bonds available in the wholesale market, this process is reasonably fast. As a matter of practicality, Market Makers usually manage their inventory so that when it looks like they’re running low of XTBs they create new XTBs, so there is no gap in XTB liquidity on ASX.
There may sometimes be limitations to liquidity on the supply side – for a bond that is tightly held by institutional investors, such as fund managers and superannuation funds, the Market Maker may sometimes have difficulty sourcing sufficient volumes to meet the demand for an XTB over that bond. Access can be limited by the liquidity the Market Maker can access in the bonds.
The Market Maker can also redeem XTBs; they will buy XTBs back when you want to sell, as long as there is a market in the underlying bonds. And because XTBs are created over corporate bonds on ASX100 companies, it is likely the Market Maker will find a market in the underlying bonds.
To date, both Market Makers have provided bids on all XTBs for 100% of the time since XTBs first launched in 2015. This means that 100% of sellers have been able to sell XTBs back to the market over this time. Interestingly, because XTBs are generally buy and hold investments, most investors have held to maturity.
Investors who hold their XTBs to maturity don’t need to rely on Market Makers as this is not a sale; the company that issued the bond repays the principal and makes the final coupon payment.
XTB liquidity is driven by, and sometimes limited by, the liquidity available to the Market Maker in the underlying wholesale bond market. If the Market Makers(s) can buy or sell bonds, it can create or redeem XTBs. As a result, the actual liquidity in XTBs is generally far greater than that which is seen on ASX screens. The Market Maker will buy back XTBs on ASX; it can do so readily because it can always redeem any XTBs back into underlying bonds that it can sell into the wholesale market.