Making ETFs work

Victoria Hartley looks at the role market makers play in the creation of ETFs and how they adapt to rapidly changing markets

Market makers are quite simply the firms that make ETFs happen.

If fund managers are the mechanics, market makers supply the mechanics with the car parts and the oil to keep ETFs running. The creation of an ETF officially starts with a regulated market maker, otherwise known as an authorised participant (AP).

For an ETF fund to be successful, it must be liquid and allow investors to trade in and out in real-time. This is not dependent on the fund’s average trading volume or the number of shares traded per day. Instead, a better measure of ETF liquidity is the liquidity of the underlying stocks in the index. 

Since ETFs trade like stocks, APs order the creation and redemption of ETF shares. Market makers build an ETF share from the shares of the companies in the underlying index. Then, they create or redeem shares depending on the market demand for the ETF shares.

Market makers and specialists can also profit along the way by creating and redeeming shares to arbitrage premiums or discounts to the underlying net asset value (NAV). This activity is beneficial to ETF investors because it keeps the price of the fund in line with the NAV, and prevents specialists from making unfair markets. This allows investors to buy and sell at a fair price.

Under the direction of the fund manager, these middlemen assemble the appropriate basket of stocks and send them to a specially designated custodial bank for safekeeping. 

“Without market makers, an ETF would be simply be a traditional fund. Market makers allow us to list the fund on a stock exchange and offer real-time pricing, instead of just providing a net asset value at the end of the day,” said Dan Draper, head of ETFs at Lyxor. “Market makers are crucial.”

What does a market maker do?

Michael John Lytle, director of marketing for Source, the Goldman Sachs, Morgan Stanley and Bank of America Merrill Lynch joint-venture, said: “There are two basic issues – counter-party risk and liquidity – and market makers provide both. Every fund needs to start small, with a dedicated trading cap, and investors need an accurately priced product.”

“The whole point of an ETF is that it is exchange traded and executes quickly in real time. Lots of people own ETF shares for years, but when they make a decision, it’s important to be able to get out when and at the price they want,” he added.

Draper said European ETFs trade at about a tenth of the average daily rate of those in the US. “So it is a challenge for market makers, but the spreads are more attractive because the markets are less efficient,” he added. 

Market makers are a diverse bunch, from the large investment banks including Goldman Sachs, Morgan Stanley and UBS to specialist outfits like Winterflood, Nyenburg and Flow Traders, with the latter both based in Amsterdam. 

The day-to-day

Bernardus Roelofs, head of ETF sales trading at Flow Traders, said the firm maintains continuous two-sided quotes – one a bid price, the other the asking price. These quotes must fall within a predefined maximum spread and minimum size for almost all ETFs. 

Roelofs said: “We provide liquidity for ETFs and exchange-traded commodities, on and off-exchange. The difference between brokers and us is that we, as a market maker, provide liquidity directly to the stock exchanges and to institutional investors, and take the corresponding risk on our own account.”

He added: “We do not use client money; we use our own. A broker is an intermediary who acts as an agent for clients, and a broker contacts a market maker when he has to provide prices or execute in the market enlisting the market maker.” 

As such, market makers make it faster, easier and cheaper for brokers to buy and sell the shares they need to on their clients’ behalf.

For a stockbroker like TD Waterhouse, charging investors around £10 for each online trade, it would be an expensive ask if they had to outlay the cash for the shares. Instead, after receiving the order, a market maker uses its own money to buy those shares themselves, facilitating the purchase for the stockbroker. 

Roloefs said market makers at Flow Traders have to understand every single aspect of an ETF/ETC, including composition, liquidity of the underlying, hedge and markets, to be able to provide the right price. 

Market makers start early in the morning and continue until after the market closes at 5pm, when orders are still coming in and prices still being given. In the morning, positions and NAVs are checked, along with the software, and traders look ahead to see what market moving announcements they will see that day, said Roelofs.

“Traders need to be alert for events that might influence the market. Special attention is given to the opening and closing auctions, as the mechanisms and dynamics during those periods are different from normal trading hours,” he added. “Every exchange is different, and traders need to understand what to do and what not do.” 

Bart Lijnse, managing director at day and arbitrage trading market maker Nyenburg, said: “We channel intra-day liquidity. We channel the money so the fund managers can take their money at the end of the day.

“What we do is post bid and offer prices at various exchanges around the globe. I check the trades and we also need to be able to give those prices to clients whenever they ask for them,” added Lijnse.

Nick Ramsbotham, ETF specialist market maker at Winterflood Securities, said his firm completes 2,000 to 2,500 individual ‘bargains’ or deals each day.

During the day, as well as taking calls from stockbrokers or institutional investors, market makers continuously watch their screens for sudden price movements.

“There is no human interaction when we buy and sell,” said Ramsbotham. “If, all of a sudden, for example, the gas price falls, my in-house system alerts me, so if we have £250,000 of natural gas, I go in and hedge that position against the intra-day risk,” he said.

Any move has to be tallied against the ETF and inputed into the system. Then there are three options, said Ramsbotham. 

He can buy natural gas on the futures market and hand the securities over to the ETF custodian, or he can offset the risk on-screen. The last option is to offset the risk with a different counter-party, like another market maker, in a way that does not ‘mark’ or show on the London Stock Exchange. 

“Sometimes these can match off and be cheaper and easier than doing it ‘on exchange’,” he added. 

Lijnse said to wrap up the day, when the markets have closed, his traders analyse the day’s events, do some research and change any processes if necessary. 

So, what constitutes a good day for a market maker? “If we make money, the trades settle and clients get their shares – that’s a good day,” said Lijnse.

Ramsbotham added: “No one does it for free. The reality is that if the market flat lines, I would struggle to make money, but there is intra-day volatility, which can be exploited.”

On-exchange, off-exchange

The underlying assets for ETF shares can be bought either on the stock exchange, which is described as on-exchange, or off-exchange, which means they do not register officially as a trade on the exchange although the assets change hands.

 “The off-exchange market is two to three times the size of the on-exchange market, and has different characteristics,” said Lytle.

“The on-exchange market tends to be smaller or retail investors, with the size of deals usually worth under a million dollars. So we’d usually talk to market makers like Flow Traders or Nyenburg for these deals. With the off-exchange we usually partner the four big investment banks,” said Lytle.

“The European market is more of a buy and hold market, so as an active trader it’s just not possible to maintain liquidity without looking for trades off-exchange,” he added.

Stockbrokers

Stockbroking firms work with a stable of market makers who continuously send their bid-offer price quotes down the wires. Consumers only see one price because stockbrokers have already pulled out the best quote from the pool of market makers quotes, which all APs are prepared to honour for 15 seconds, giving the broker enough time to execute the deal.

“In the case of online trading, if the deal can’t be done automatically online, it could be that the market maker isn’t offering the most competitive price, so we would buy the shares on the investors behalf,” said James Daly, investor centre representative with TD Waterhouse.

“We have to deal at the best available price and if the market makers are not offering it, we have to intervene. So, clients get an error message on-screen and have to phone to complete the trade,” said Daly.

The way ahead

But, Lytle said, however integral the role of market maker is to the way fund providers run their products, in some cases these relationships are not helping the European market reach its full potential.

“You have to look at the mechanics of ETF products. Although the system works, the average product lists on five or six different exchanges in different countries for distribution reasons,” he said.

Market makers then split their capital between five or six different countries, decreasing the depth of the market in each place, said Lytle.

“I understand why providers have done it, but it’s better to make the base product more liquid, especially when 90% of European ETFs are held by institutional investors, not retail investors,” he added.

Manooj Mistry, head of db-x trackers UK at Deutsche Bank, said he would like to see more official on-exchange market makers, who are officially registered and fulfil certain quoting obligations.

“To give the market more confidence, it would be good to see more market makers becoming officially registered, to give investors the impression these funds are traded by more counterparts,” he said.

Ramsbotham from Winterflood Securities disagrees, saying: “The bigger the inventory you have, the more financing you have to hold up. At the moment, we can provide liquidity at any time.”