Trading in the open

The development of the trading market for exchange-traded funds in Europe will depend on improvements in the reporting of off-exchange activity, though the wait for European legislation will be a long one. Further benefits would result from greater diversity among ETFs and better reporting technology at exchanges. Richard Jory reports

Michael John Lytle

The trading of exchange-traded funds (ETFs) in Europe is far greater than it first appears, mainly because the trading figures released by stock exchanges do not include the vast wealth of the investments that change hands in the over-the-counter market. But this truth cannot disguise the drag on market development that is being caused by the high degree of similarity between ETFs in Europe, most of which trade in low volumes on a multitude of exchanges.

“European ETFs do not begin to see the levels of trading turnover that exist in the US ETF market. Europe has daily on-exchange turnover of around 1% while the US has 10% plus. We have been making inroads in creating US levels of trading volume in our sector products and have over 15% daily assets under management (AUM) turnover,” says Michael John Lytle, London-based director of marketing at ETF provider Source.

BlackRock estimates that ETFs traded over the counter in Europe account for two-thirds of the market, which suggests that 3% of AUM changes hands, although others trading the products say the true percentage of ETFs traded in Europe is much higher.

Exchange-traded funds based on benchmark indexes such as the FTSE 100 or Dow Jones Eurostoxx 50 feature good liquidity and tight spreads, and trading on these benchmark ETFs accounts for as much as 30% of their AUM in Europe. But elsewhere liquidity is often low and spreads are therefore wider. Asia-orientated ETFs, for instance, have wide spreads because the underlyings are closed as the local trading day is completed as morning trading starts in Europe. “For a market maker to hedge this, they must find another instrument with a similar risk profile or take a risk on their books. Due to the underlying sector liquidity and the highly traded corresponding futures, liquidity on the sector ETFs across Europe can be good,” says Matthew Carr, BNP Paribas managing director and ETF specialist at EasyETF in London.

One hope for improved transparency in the European market is that trading figures reflecting the entire region will be revealed once new legislation is enacted in the form of the European Union’s second incarnation of its Markets in Financial Instruments Directive (Mifid). Mifid II is currently still in the discussion phase, though the talks have included proposals to make the reporting of all ETF trading mandatory, including off-exchange.

Issuers have so far lobbied for the inclusion of off-exchange ETFs in trade reporting, arguing that, while ETFs are funds, they resemble  equities and should therefore be reported under Mifid.

“Although ETFs look, trade and settle like an equity, they do not fall under the same price reporting requirements of Mifid,” says Carr.  “Consequently, the on-exchange volume can appear relatively small, certainly compared with the true traded volumes, the majority of which are currently traded off-exchange by market makers, where there is no obligation to report like there is for an equity. This hinders further trading because people think there is limited liquidity or on-exchange volume on European-listed ETFs.”

While the inclusion and implementation of the trading data would put reporting practices in European market on a par with those of the US market, the drawbacks of too many trading venues and too many products based on the same indexes, which have marked the early development of ETF trading in Europe, will continue.

The platform route
Historically, ETFs in Europe have had two types of market maker. The first gave prices off their own book to institutional clients or went through the creation-redemption process, where they were ultimately reacting to client flows. The second is the arbitrage market maker, which continuously post on-exchange prices while looking for the arbitrage opportunity between the underlyings and the ETF net asset value, or the bid-offer spread of the ETFs. “These market makers are very technology driven and may not have clients as the source of their trading, but they do ensure that the ETF net asset value cannot drift too far from the that of the underlying index” explains Carr.

A newer type of market maker comes in the form of platforms created by financial institutions such as Source and ETF Securities, which owns ETF Exchange (Europe), or ETFX. These two companies’ platforms resemble those used in the US and are based on create to lend (or the short side of the ETFs) for clients – mainly hedge funds who want to borrow rather than invest in ETFs.

On February 10, ETF Securities announced that Barclays Capital has joined its ETFX platform as an authorised participant and swap provider. ETF Securities is also working with Bank of America Merrill Lynch, Citi and Rabobank International, and plans to add more participants.

“If you look at the core nucleus of Source, they are all large prime brokers:” says Carr. “And as we can see in the US, hedge funds are extremely active ETF trading firms. Thus Source are obviously looking to create an ETF short and lending market in Europe and capture the corresponding fees in their prime brokerage platforms and trading desks,” he says.

Source’s Lytle adds: “Our optimised sector ETFs offer hedge funds an alternative to OTC sector swaps. Owning an ETF reduces the counterparty risk inherent in OTC swaps and is much more operationally efficient. The Stoxx 600 Optimised Supersector indexes that we track offer better balanced and more liquid exposure to the sectors they track. The optimisation methodology is similar to the adjustments that many clients were making when constructing their own OTC sector swap baskets. Migrating from a sector swap to our sector ETFs is relatively seamless. The client can trade it with a range of counterparties both putting on and taking off the exposure, which they can’t do with an OTC swap position.”

Source captured 73% of trading turnover in the sector market in December, according to Cascade, the German clearing system that captures on- and off-exchange data for all participants.

Too many venues
As well as being hamstrung by the plethora of similar products available in Europe, the market has also suffered from the number of exchanges on which ETFs have been listed. The presence of multiple listing venues has reduced the liquidity of ETFs on individual exchanges and led to delays in introducing the technology necessary for efficient trading.

“One problem in Europe is that there are too many trading venues and issuers list on lots of exchanges,” says Lytle. “If you are an investor, where do you go? Prices are all over the place. For many of our products, we list only on Deutsche Börse, partly because they have double the market share of the next largest exchange for ETF volumes.”

The plethora of European trading venues matters less to institutional clients, which can generally trade on any exchange. Drawbacks only arise with retail investors, who represent less than 10% of the ETF market in Europe compared to 50% in the US.

But changes will occur as the market develops and regulatory initiatives push the European market more towards US practice. Rather than having access to market makers, US investors are served by the advisory-based intermediary model. “In Europe, retail intermediaries are predominantly retrocession based, but forthcoming regulation such as the UK Financial Service Authority’s retail distribution review, due for implementation in 2012, will likely change the way intermediaries generate income and put ETFs on a more level playing field with mutual funds given that today ETFs on the whole do not pay retrocession” says Carr.

“A large proportion of both intermediaries and retail investors are not fully educated on ETFs,” he says. “They don’t know the advantages, disadvantages, what too look out for, the ETF or the underlying index objectives and the key benefits such as transparency and intra-day liquidity.
“Education is happening, but Europe is still three to five years behind the US,” he adds.

“Intermediaries need to understand the difference between an active manager, a mutual fund, an index fund and an ETF. But even now, fund distribution companies are being forced to offer ETFs on their platforms as their clients are increasingly asking for them. They will to have to re-engineer their platforms to cater for ETFs, which trade just like a listed equity, intra-day exchange trading, settlement and custody, which is very different from the net asset value once-a-day trading of an index or mutual fund. ”