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The rapid growth of exchange-traded funds - which track a stock index, or some other group of assets - has fed speculation about what happens in the next big market collapse: Will ETF values still rise and fall with the companies' underlying fund? Or will investors find themselves with devalued ETFs that become tough to unload, except at a discount to the stocks their prices are supposed to be based on?

ETF assets - an industry dominated by New York-based BlackRock's iShares, Vanguard Group of Malvern, and State Street Boston Corp. - grew from under $1 trillion before the 2008-09 recession, to $5 trillion as of June, according to the ETF research and consulting group ETGFI. But new purchases slowed earlier this year to half of 2017 levels as stock market gains slipped.

"ETFs introduce new noise into the market," according to a 2015 paper initially published by the SEC and written by a group of scholars including Rabih Moussawi of Villanova University. In a 2017 follow-up, they noted that ETFs had come to account for one-third of market trading, and that "ETFs impact the liquidity of the underlying portfolios, especially during events of market stress."

Like other stocks, ETFs require a busy ("liquid") market of buyers and sellers to accurately represent changes in the value of the companies they represent. New ETF shares can be created by brokerage firms who buy the underlying securities and trade them to ETF issuers such as BlackRock in exchange for the new ETF shares.

As ETF volumes rose, a handful of firms have come to account for a large share of ETF trades. In 2016, a concerned Securities and Exchange Commission began requiring ETFs to disclose which traders they rely on to help keep valuations close to market levels. Those reports show Susquehanna Investment Group, a 2,000-person, Bala Cynwyd-based trading firm, has become one of the leading ETF markets, reported Bloomberg's Annie Massa in a story tracing the firm's risk-calculating rise from a band of traders led by Jeff Yass and backed by Izzy Englander (now head of hedge fund giant Millennium Management) on the floor of the Philadelphia Stock Exchange in the 1980s.

What's in it for Susquehanna? Besides the ease of making short-term bets on market moves, ETFs' appeal "was the flexibility it offered for hedging, arbitrage, and portfolio diversification," Massa wrote. Susquehanna creates and redeems about 100 million ETF shares worth $1 billion a day.

Susquehanna, with offices across North America, Asia, and Europe, has for more than 20 years shifted partners' (and sometimes customers') assets in and out of stocks, futures, options, commodities, and even municipal bonds in search of price anomalies - sometimes very small gaps that it can exploit (arbitrage) with quick, well-timed, high-volume trading. The firm is famous for teaching its math-oriented recruits how to play poker as preparation for options and futures trading.

Susquehanna alumni who have founded large new ETF-trading hubs of their own include: Reggie Browne, the "Godfather of ETFs" at trading giant Cantor Fitzgerald & Co.; Chris Hempstead, who built the ETF business at Virtu Financial's KCG Holdings Inc.; and Tim Reynolds, Rob Granieri, and Michael Jenkins, who founded Jane Street.

According to Bloomberg, the SEC and the federal Financial Stability Oversight Council, along with ETF sponsors like Vanguard, have raised concerns about the impact of "severe market stress," and that the market "is vulnerable to breakdowns" because of its reliance on the handful of big market makers. While Susquehanna isn't backing down on ETFs, it is spreading its bets, expanding its cryptocurrency trading and moving (through its Irish subsidiary Nellie Analytics) into sports betting.

"Unlike single shares, the supply of ETFs is open-ended," notes Vanguard in a paper posted on its Website that seeks to reassure investors. "New ETF shares can be created and existing shares redeemed based on investor demand," and "without significantly affecting the ETF's price." That's because the market-making traders help "maintain a fair and orderly market by selling ETF shares to potential buyers and by buying ETF shares from potential sellers. In the absence of another buyer or seller, a market maker can often match the other side of a pending order."

The big market makers "earn a commission on their transactions," Vanguard added, and can resell shares" at a small margin above" their cost. "The liquidity of the underlying securities in the creation/redemption basket is what matters most. When the underlying securities are difficult to trade, the market maker's costs may increase, resulting in wider bid-ask spreads than usual or compared with ETFs in other asset classes."

Does that mean Susquehanna's billionaire owners are clipping profits at ETF investors' expense? That's how securities markets have always worked. "Robust competition within the trading ecosystem ensures that ETF transaction costs are fair and in-line with the costs and risks incurred by firms when providing liquidity," Vanguard spokeswoman Farrell told me. "Competition across trading firms ensures that ETF prices closely track net asset values and ensures that investors receive a fair price when transacting."

The market needs the traders: "Without liquidity, no one (would be) interested in trading" ETFs, said Barry Ritholtz, a New York investment adviser who sells Vanguard ETFs and other funds.

But will they be there the next time the market panics? The worry is "that the ETF market could behave like the credit market - liquidity could dry up in times of stress if the usual counterparties (and) facilitators step back from the market," said Jeffrey Del Maso of Adviser Investments, another New York firm that sells Vanguard funds, among others. "It's a risk. But proponents of ETFs says that most trades happen on the exchange investor-to-investor, not via authorized participants.

"I don't really know. We'll find out in the next bear-market crisis."

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