Trading in the dark

The majority of ETF trades in Europe are transacted over the counter, rather than via an exchange. Helen Fowler looks at how this affects the European market and the potential for regulatory change

There is a curious irony to buying and selling ETFs in Europe. The name suggests the products would be traded on exchanges, but in fact this is not always the case. Up to an estimated 75% of European ETF trades happen over the counter (OTC), without going near an exchange. A legislative anomaly meaning that none of these trades are required to be reported has created a damaging and false impression of the European market as smaller than it is. 

Official snapshots of European ETF activity are misleadingly small. Although official daily trading volumes in the European ETF market are only around US$2.7bn, once OTC trading is included the real daily total is probably closer to around $9bn. Low volume figures have the circular effect of keeping many investors, both retail and institutional, out of the European ETF market. 

Bart Lijnse, managing director at Netherlands-based ETF market maker Nyenburgh, said: “The optically low liquidity of many ETFs deters many investors from using those ETFs, or, if they do trade them, leads them to execute their order OTC, since they believe there is no liquidity on screen.” 

Limiting investment

Poor official liquidity levels are effectively forcing institutions that would prefer to trade on exchanges into the OTC market. Or in some cases, institutions have to forsake Europe altogether and go instead to the US ETF market, where they can buy similar ETF products more easily. However, this can be costly in terms of extra taxes.

The only on-exchange trading in Europe is by investors prepared to trade in small amounts of around €500,000 or less, tiny by institutional standards. For larger trades, institutions may check the official exchange prices but they will almost inevitably have no choice but to pick up the phone to a broker and do the transaction OTC. 

Low official trading volumes are thought to be keeping retail investors out of the European ETF market. “One of the many reasons the retail investor isn’t there is because they can’t access the OTC market,” said Richard Keary, principal at Global ETF Advisors, a US-based consultancy firm. Estimates suggest retail investors account for only around 10% of the European ETF market, compared with 50% in the US.

Even including OTC trading, European ETF volumes remain small next to the US, where average daily trading volume, which includes mandatory reporting of OTC trades, is $57.8bn, nearly six times that in Europe. 

Although European ETF assets continue to mushroom, hitting an all-time high of $204bn at the end of September, official average daily trading volumes still account for only 1.3% of assets. In the US, this figure is 27%, meaning investors can execute high frequency trades that would be unfeasible in Europe. 

Lijnse at Nyenburgh said: “The ETF market in Europe is relatively illiquid. The ratio of trading volume to assets is much lower in Europe than in the US.” The problem is that when potential investors see small trading figures in Europe, they are less likely to venture into the market and therefore increase official volumes. Manooj Mistry, head of db x-trackers UK, said: “It’s to do with the perception that when people think about products and liquidity, their natural instinct is to think it’s not liquid.”

Lijnse explained that it is usually impossible to work an order on exchange against natural order flow, because liquidity is so fragmented. He said: “In some ETFs you might find a quote for €500,000 on screen but you won’t find anything around €3m. Smaller trades in those ETFs go on exchange but bigger trades go OTC, where they are less visible.” 

Deborah Fuhr, global head of ETF research and implementation strategy at Barclays Global Investors (BGI) said: “Many people don’t understand why OTC trades are not required to be reported in Europe, so they don’t realise that 70% of trades are done OTC. Hence they just look at the volumes reported on exchanges in Europe and think that ETFs in Europe are not liquid.” 

Keshava Shastry, head of markets at BGI’s iShares said that publicising true liquidity levels in Europe would lead to higher turnover. He said: “As soon as you start printing, more market makers will get involved and spreads will get tighter. You will get a circle of liquidity. With better liquidity it’s much easier to go in and out of products cheaply and anonymously.” 

BGI’s Fuhr said: “Liquidity begets liquidity. There is a benefit in reporting trades. It helps price discovery, valuing investments and proving that products do track their benchmarks. It’s about proving a concept.”

Better liquidity would enable investors to buy and sell in large quantities without impacting the price to their detriment. Increased trading volumes should mean that market makers would have more price certainty from which to price funds. If more trades were reported, the industry would dispel the false image of the European market as illiquid. 

Patrick Humphris, a spokesman at the London Stock Exchange, said exchanges offered security of settlement, with trades settling through a clearing house. “The benefits of trading on exchange are that it’s open, transparent and neutral,” said Humphris. 

ETFs and Mifid

The reason that OTC ETF trades in Europe do not have to be reported to an exchange or data provider is because ETFs were excluded from the European Commission’s Markets in Financial Instruments Directive (Mifid). The directive, introduced in November 2007, omitted ETFs from its definition of shares and so did not subject them to its transparency regime. Some market participants believe this was an unintended oversight by the Commission, although it may revisit the issue during the next round of Mifid, details of which are due to be revealed towards the end of 2010 or the beginning of 2011.

Leading providers are lobbying to ensure Mifid II covers ETFs. BGI is among those firms calling upon the Mifid decision-makers to make the OTC market in ETFs more transparent by forcing firms to make all OTC trades public. Shastry at iShares said: “We are lobbying the European Commission, the Committee of European Securities Regulators, the Federation of European Stock Exchanges and individual regulators.”

Keary at Global ETF Advisors said: “Mifid II is looking to create a consolidated tape across Europe where traders will post their best price and disseminate it in real time to all investors across Europe.”

ETF providers are also asking investors to insist that their brokers report OTC ETF trades. Shastry added: “We are working with many brokers to collate OTC trading information voluntarily. Over the last nine to twelve months they have been active in doing this, because they can see the benefits of a more transparent market. Over the last four to five months the momentum has really gathered.” 

Shastry continued: “A lot of systems and IT developments that are needed are already in place due to cash equity trade reporting requirements. So the incremental costs or development to implement ETF trade reporting would be minimal.”

Transparency issues

As problems have surfaced in other parts of the OTC market, notably in credit derivatives, internal pressure is growing on brokers to introduce greater transparency and avoid the OTC market. Keary said: “More and more banks trading in the ETF OTC markets will feel obliged from a compliance point of view to put trades on tape. There is momentum for brokers to put more of their trades on the tape even though they are not required to do so under current regulations.” Keary said he was aware of demand among clients for brokers to record their trades. 

Humphris at the LSE also noted a wider industry trend towards trading on exchanges. “OTC is a much more impenetrable market, especially for retail,” he said. 

However, Michael John Lytle, director of marketing at Source, the ETF provider working in partnership with Morgan Stanley, Goldman Sachs, Nomura and Bank of America Merrill Lynch, warned that requiring trades to be reported on exchange would not necessarily translate into more trading happening on exchanges. He said: “It is difficult to change investors’ trading patterns. You can force them to disclose the trade. Disclosure creates post-trade transparency but it doesn’t create liquidity.” 

Keary at Global ETF Advisors said there might be opposition to disclosing the terms of OTC ETF trades from banks who profit from generally wider margins on these transactions. 

There is a possibility that Mifid II, like its predecessor, might exclude ETFs from its provisions. Keary said: “Since ETFs were not in Mifid there is concern they might not be included in Mifid II. From what we’ve heard, the European Commission is looking at ETFs, asking whether, if they include ETFs, then should they include all other derivative products. We are trying to get the industry to lobby and say ETFs should be included and not lumped in with derivative products.”

The administrative work required to collate and report trade details may be off-putting to some firms. Fuhr at BGI is among those sceptical that firms will do this voluntarily. “Brokers are not going to do work they don’t have to do,” she said.

Despite these difficulties, the benefits to the ETF industry of making OTC trading more visible appear to outweigh the disadvantages, suggesting that it can only be a matter of time before, one way or another, ETFs in Europe are traded in greater quantities on European exchanges, or at the very least reported there. If that happens, as most industry observers believe it eventually will, ETFs in Europe will at last have a chance to live up to their names.