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David Mann, Director, is Head of the Regulatory and Market Structure group within the Americas iShares Capital Markets team. His group manages exchange and market maker relationships and analyzes the potential impact of market structure and regulatory changes on the ETF landscape. Mr. Mann's... More
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  • Meet The Market Makers: The ETF Ecosystem At Work

    In my last post, we introduced you to the who of the ETF ecosystem. We defined the various types of market makers (MMs) and other market participants, and explained what role each plays in the everyday trading of ETFs. Today we are going to discuss why these players are in the ETF ecosystem - how their business models differ and what motivation they each have for trading ETFs.

    Why is this important? Simply put, the interaction between these different market players can lead to liquidity for the investing public. Furthermore, any of the recent discussions around regulatory changes for market makers - for example, their obligations within the marketplace - must start with the strategies these firms employ. This understanding may also help dispel fears around a potential breakdown in trading leading to illiquid markets in ETF securities.

    Of the many market participants, there are 2 main categories which facilitate ETF trading on a daily basis: Authorized Participants and Market Makers. The visual below explains how each interacts with ETFs on a regular basis.

    (click to enlarge)Authorized Participants (APs)
    On the primary market side, Authorized Participants provide a service by transacting with an ETF sponsor to manage the supply and demand of ETF shares in the marketplace. Some APs will create and redeem new shares to manage their own inventory, while those who do not engage in market making simply facilitate creations and redemptions on behalf of their clients (which could include market makers). Even the concept of 'create to lend' - creating new shares in order to lend them to a short seller - is simply another example of client facilitation.

    Market Makers (MMs)
    What incentive do market makers have for making two-sided markets - and therefore providing liquidity - in ETFs? We see a couple of different business models in the MM space.

    The first are firms that seek to take advantage of possible arbitrage opportunities between their own calculated 'fair value' and the price of the ETF in the secondary market. Arbitrage refers to the simultaneous purchase and sale of an asset in order to profit from a difference in the price.

    If, for example, an ETF's secondary market price is higher than the fair value a MM has calculated for that ETF, the MM will sell the ETF, purchase a correlated security as their hedge such as the underlying basket of securities, and then utilize an AP to create the ETF to cover their short position. As we discussed earlier, the market maker and AP could be the same firm. Often these price discrepancies are quite small and can disappear almost instantly. In fact, one of the main reasons ETFs typically trade so close to their underlying value is because of the quantity of firms that use this type of strategy.

    Now, approximating an ETF's fair value is not an exact science - especially for US listed ETFs with international underlying securities since foreign markets can be closed when US markets are open. These firms do take a risk when utilizing an arbitrage strategy. The MMs calculate this value based off of a number of factors - it can be as simple as pricing the ETF off of the underlying basket or as complicated as adjusting via the performance of correlated securities.

    The second MM business model we see are firms that trade ETFs in the same way that they would trade any equity, like PG or MSFT. This group looks to capture the bid/ask spread as well as rebates from the exchange's maker/taker pricing model. The bid/ask spread is fairly self-explanatory - if MMs can buy on the bid and sell on the offer, then they will make the difference after any associated transaction fees. The maker/taker pricing model is where stock exchanges pay rebates to those who provide liquidity and charge a fee for those who take the liquidity. If a market making firm can make more liquidity then they take, they will receive more in rebates from the exchange then they would pay in fees. This type of activity is more common in highly liquid ETFs.


    As you can see, each market participant in the ETF trading ecosystem has a different business model when it comes to trading ETFs, and all are interacting to provide the liquid markets that the public has come to expect.

    The one main driver for success in any of the above market making models is trading volume. But what happens for new and less liquid products that have low trading volume? We will conclude this series with a discussion as to why this is an issue and the steps the exchanges are taking to solve it.

    Although market makers will generally take advantage of differences between the NAV and the trading price of iShares Fund shares through arbitrage opportunities, there is no guarantee that they will do so. With short sales, an investor faces the potential for unlimited losses as the security's price rises.The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective.iS-8209-1012

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Nov 13 7:22 AM | Link | Comment!
  • Meet The Market Makers: Your Guide To The ETF Trading Ecosystem

    It has now been about a month since a computer error cost Knight Capital a reported $440M. This was the latest incident (Flash Crash, BATS IPO, and Facebook IPO) that called into question the current state of affairs of market structure in the United States. As one would expect, the stories were fast and furious. The system is broken! Machines are out of control! Regulators must act today!

    While the erroneous trades in this situation mostly affected individual stocks, Knight's status as the lead market maker (LMM) for over 400 exchange traded products raised questions about how an event like this could impact the ETF space. How important is a lead market maker compared to the other market participants that are trading a product? More importantly, if an active market participant suddenly disappears from the ecosystem - for example, due to a Lehman type event or a significant regulatory change - how could it impact ETF trading?

    The truth is that there are actually multiple players in the ETF ecosystem -market makers (MMs), lead market makers (LMMs), designated liquidity providers (DLPs) and competitive liquidity providers (CLPs), to name a few. To help make sense of the alphabet soup that is an ETF's trading lifeblood, I've created a handy visual below to explain who does what.(click to enlarge)A couple of points I'd like to highlight - first, the terms AP and MM are often used interchangeably, as many firms serve in both capacities. This can cause confusion as to who is responsible for what within the ETF ecosystem, especially in a Flash Crash type of event. The simple answer is that if a firm is making markets in an ETF on an exchange, and then that same firm performs a creation at the end of the day to manage their inventory, it's actually serving two distinct roles within the ecosystem.

    Also, putting numbers to each of these groups is an inexact science considering the number of exchanges and sponsors. We estimate there are at least 100 firms who provide liquidity in ETFs in some capacity. Of these 100 firms, we estimate that there are approximately 20 who are registered as market makers at the exchange. Of these 20 firms who are registered on the exchange, approximately 10 of them act as an LMM/DLP/CLP in some capacity.

    The role of the LMM (or DLP, or CLP) is an important one - particularly when an ETF first launches - but it's not the "end all be all" of an ETF's liquidity. While an LMM can play an important role in the early days of a new ETF's trading, it becomes less important as a product becomes more liquid (more on this in a future post). In addition, ETFs trade on all exchanges thanks to another acronym known as UTP (unlisted trading privileges). And we often see that for our more liquid products, the listed exchange will not even account for more than a third of the total traded volume that day.

    The bottom line is that having so many active firms in the ETF ecosystem can lead to liquid markets that trade in line with the fund's intraday fair value. The competition between these firms - each of whom may have very different business models - gives investors options when it comes to getting the best execution as well as creating multiple trading "buffers" within the ecosystem.

    Now that we have the definitions straight, my next post will dissect an ETF trade, showing examples of how these entities interact as well as giving some context around their different business models.

    Shares of ETFs may be sold throughout the day on the exchange through any brokerage account. However, shares may only be redeemed directly from a Fund by Authorized Participants, in very large creation/redemption units. There can be no assurance that an active trading market for shares of an ETF will develop or be maintained.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Nov 13 7:22 AM | Link | Comment!
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