In the Engine Room of European ETFs

Jun.10.09 | About: iShares iBoxx (LQD)

By Paul Amery

How an exchange-traded fund trades can be nearly as important as the index it is designed to track. After all, it does you no good to identify an index that outperforms a cap-weighted benchmark by 1% per year if it costs an extra 2% to buy and sell the fund.

The group in charge of determining how ETFs trade are the “market-making firms”—traders tasked with maintaining two-way price quotes throughout the day in all of Europe’s 700+ ETFs.

Little-known by comparison with exchange-traded fund issuers, these market-making firms perform a vital service, ensuring that ETFs and other exchange-traded products fulfil their key characteristic of tracking the underlying securities’ net asset value. Indeed, one leading European ETF issuer told me recently that understanding how the market makers operate is the key to understanding the whole exchange-traded products business.

But who are these firms, and what influences their pricing of ETFs and ETCs? More practically, what can we learn from understanding how these firms operate that will help us trade better? spoke last week to several leading market makers to find out.

Who Are The Traders?

Some of the key traders are market-making firms like Flow Traders, Nyenburgh, Susquehanna, Labranche, Timber Hill, Saen Options, IMC, Madison Tyler, Geneva Trading, All Options and Optiver, many of which are privately held companies, often with a background in options and proprietary trading.

The “delta-one” desks of banks such as Unicredit, Morgan Stanley, Societe Generale, Deutsche Bank, UBS, RBS, JP Morgan, HSBC, Citigroup, and Goldman Sachs form another important group of market makers, since they have long-standing relationships with the institutional clients who are the main buyers of ETFs.

The first list of firms has traditionally operated as principals in the trading arena, buying and selling for their own account, while the banks have tended to focus on client business as agents or brokers. Recently, however, these distinctions have blurred, with several market makers moving to deal directly with investing institutions, and the banks trading for their own account as well.

There is also a significant overlap between the trading firms’ roles as Authorised Participants (“APs”) to ETFs (which makes them able to create and redeem ETFs in the primary market, and is set by agreement with the ETF issuers) and their role as official market makers, which is a contractual agreement with the exchanges on which the ETFs are listed, and subject to published obligations regarding the maintenance of minimum quote sizes and maximum dealing spreads.

In practice, a firm that signs up to the responsibilities of an official market maker will tend to be an AP as well, since this guarantees that it can use the ETF creation/redemption mechanism, where necessary, to make large trades.

What Influences an ETF’s Secondary Market Price?

The secondary market bid-offer spread for an ETF is influenced by a number of factors, but a major one is undoubtedly the liquidity of the underlying securities. Benjamin Fussien, head of ETF sales and trading at Societe Generale in Paris, showed at the recent EDHEC conference in Paris that average trading spreads on large-, mid- and small-cap equity ETFs in Europe doubled during September and October last year, reaching nearly 50 basis points for small-cap funds and nearly 20 basis points for large caps. This, in turn, reflected the dramatic rise in overall market volatility, which caused market makers to widen their quotes. While spreads have since contracted somewhat, they remain above pre-September levels.

As we reported on in October, a much more extreme spread widening took place in corporate bond ETFs, with double-digit discounts to reported NAV appearing on some funds. According to Roger Hodenius, managing director at Amsterdam-based Flow Traders, the cost of creating or redeeming the iShares $ Investment Grade Corporate Bond ETF (NYSE: LQD) exceeded 10% at the peak of the market panic, meaning that the “official” prices that made up the fund’s indicative net asset value did not reflect reality.

While the impact of such market events would affect all investors, other factors can affect an ETF’s secondary market price. These include the effect of any local fees or taxes in a given European market on the cost of an ETF creation or redemption, the cost of hedging when the underlying market is closed (more on this below), and any implied foreign exchange conversion, which would apply when the fund’s trading currency is different from the typical currency denomination of the underlying asset(s). The location where the trade is placed can also be important.

When Is Best To Trade?

An ETF’s liquidity is in many cases directly related to that of the underlying asset market. As a result, it often makes the most sense to place orders for the ETF itself when the underlying market is open for trading.

For example, Asian stock exchanges shut early in the morning in European time, but it’s still better to place a trade in a Hong Kong equity ETF at 09.30 CET, when the market has just closed, than later in the European day, said Hodenius of Flow Traders. US equity ETFs are clearly likely to be better priced in European trading after US exchanges open at 15.30 CET. And in some commodity markets, exchanges have odd hours on a European clock – Chicago wheat futures, for example, are open until 13.00 CET, then close until 16.30, then reopen with the best liquidity of the day.

ETFs still trade outside the opening times of the underlying asset markets, but for market makers, pricing those ETFs may be more of an art than a science. Often, there may be “offshore” markets, such as those for ADRs and GDRs, to help establish trading levels in the underlying equities when home markets are shut. Otherwise, proprietary correlation models can be used to work out what a fund’s price should be. Market makers are cagy about revealing precisely how they do this, as it goes to the heart of how they operate. Other things being equal, though, buying or selling an ETF that’s priced in this way will be subject to slightly higher bid-offer spreads.

Where To Trade?

According to the market-making firms spoke to, 50-70% of European ETF trading still takes place off-exchange or over-the-counter (“OTC”). Institutions wishing to trade in ETFs can therefore survey the prices quoted on different European exchanges and the new multilateral trading facilities (“MTFs”), as well as calling the market makers directly, before choosing the best option.

Retail investors in ETFs are much more constrained, since they typically have no choice other than to buy or sell their locally listed funds, which may mean that they do not necessarily achieve “best execution” from a Europe-wide perspective.

Bart Lijnse, managing director at Dutch trading firm Nyenburgh, explained that market makers’ obligation to maintain screen quotes across different European exchanges necessarily tends to fragment liquidity, and the recent appearance of trading venues like Turquoise and Chi-X has added to the process of dispersion. Lijnse added that, from his firm’s experience, trading liquidity tends to converge to an ETF’s primary listing location.

Market makers had varying opinions about the ideal business plan for issuers, which have historically tried to cross-list popular funds across the region and on several exchanges. Source ETF, by contrast, has broken with the traditional cross-listing model in an attempt to concentrate trading liquidity in one venue, on the German exchange. One trader said he saw Source’s move as a way of testing the water with its funds, to be followed by further listings in due course, but another said he saw merit in the new issuer’s strategy.

While further consolidation of European exchanges might help in reducing the number of trading venues, John Keogh, managing director at Susquehanna in Dublin, expressed a view that the creation of a single European depositary was more important, since the existence of multiple settlement systems makes it difficult for a trading firm to net off positions created in different markets in the same ETF. This is important, because if a market maker cannot automatically match a long position in an ETF in one European settlement system with a short position in another, the trader’s capital limits will be taken up and the prices he quotes will inevitably be less competitive.

However, on the same subject, Nyenburgh’s Lijnse pointed out that there is already an EU initiative in place to harmonise settlement systems across the region, called Target 2 Securities, but few people he had spoken to expected the project to result in substantive change by the initial target date of 2012, he added.

Laurent Kssis, head of ETF sales trading at Labranche Structured Products in London, argued that European ETF market liquidity trends are the opposite of those in the US. In the US, he said, most secondary market ETF quotes are retail investor-driven. The limit orders that US retail investors typically place with broking firms create transparency and a significant depth to liquidity, Kssis explained, and the existence of rules such as the SEC’s Regulation NMS also ensures that OTC orders are reported on-exchange. In Europe, by contrast, secondary market trading activities are much less transparent, and market makers have so far proved reluctant to pay exchanges to report the trades they conduct elsewhere.

How To Trade?

Investors can choose between a variety of routes when placing an ETF trade. Institutions can execute an order by trading at the prices that the market makers quote on screen they can enlist the services of a broking firm, or they can call the market makers directly to trade “over the counter”.

European retail investors will have to trade with a stockbroker or trading firm in their own country, whose ETF prices will be set by the wholesale market, probably with a slight mark-up in price. Their orders will be amalgamated by the broker and end up as an exchange transaction, or a trade with one of the OTC market makers.

For larger, institutional trades, it is also common to place an order to buy or sell an ETF at the official end-of-day NAV. This route is a trade-off between cost (lower, since the trade is executed at the mid-market price) and the market risk that the investor takes on between the time of placing the trade order and the market close. This risk can be significant, and in the US some commentators have even blamed (leveraged) ETFs for exacerbating late-day market volatility. As we reported two weeks ago, db x-trackers has recently started to offer the facility to trade at NAV to its smaller clients, albeit subject to a transaction fee.


A variety of factors—the underlying securities’ liquidity, market opening times, the existence of multiple trading locations, and the way in which an order is given – can affect the way that an ETF is priced in the European secondary market. But whether you’re an active trader or a buy-and-hold ETF investor, understanding how the market operates is key to keeping costs down and putting together a successful portfolio.