The price is right for ETFs

Paolo Giulianini, head of ETF trading and advisory at UniCredit, speaks to Emma Dunkley about liquidity and the role of the market maker

ETFs are hailed for their many benefits, with liquidity chief among the range of attractions. Priced continuously throughout the day, ETFs are easily tradable for investors seeking to gain diversified exposure to a wide spectrum of asset classes. Behind the scenes, this intra-day liquidity is powered by market makers, who must maintain continuous ETF quotes during the whole trading session, regardless of whether the underlying market is closed and despite any other potentially impeding factors. 

“The market maker signs a binding agreement with the ETF issuer and the exchange, so he or she has to ensure the liquidity of the ETF and is obliged to quote on screen throughout the day,” says Paolo Giulianini. Having spent over 10 years in the delta one and ETF industry, Giulianini is highly experienced in the role of market maker and authorised participant, witnessing the growth of the market since Europe’s inaugural ETF was listed in Germany and then on the London Stock Exchange. 

Market makers focus on liquidity provision in the secondary market, working to keep a narrow bid-ask spread, rather than being involved in the creation/redemption process. Each ETF can have a number of market makers, and generally, the larger the number, the tighter the bid-ask spreads, due to the element of competition. 

In another role, Authorised Participants, or APs, deal in the primary market and are able to trade the underlying basket of stocks against the ETF; they then create new shares and make redemptions. In order to do this, APs sign a contract with the ETF issuer. The AP can settle the underlying basket of stocks in cash or in kind, delivering this to the ETF issuer. Giulianini says: “This is the moment in which you really see an increase in the number of ETF units in the fund – only when there is a trade between an AP and the ETF issuer.” At the same time, certain APs can be market makers, and vice versa. 

Secondary market

There are a number of issues that arise in the secondary market, which market makers have to deal with. For example, ETFs in Europe are cross-listed on different exchanges, although the transfer or re-registering of ETF units from one exchange to another is not as simple as pressing a button. 

The lending desk also plays an important role in dealing with all participants, in order to borrow from long orders. “We have a huge inventory of ETFs, so we are happy to lend them out,” says Giulianini. “On the other hand, we also need to borrow – for example, we might have a position settled in Switzerland but we are selling in Italy. Or we need to sell to settle in Germany, where the trading phase is always T+2 days, when in all other countries it is T+3.” 

As both AP and market maker, Giulianini is well-placed to notice trends in ETF trades. “We’ve seen a lot of interest in emerging markets ETFs and we’re seeing a move towards investing in regions, rather than specific countries. There’s always good flow in country-specific ETFs, but a year ago there were more bets on Brazil, Russia, India and China, for example. Now, we see more interest in the broader emerging markets ETF, or Latin America or Emerging Asia funds.” In Europe, Giulianini is also seeing a lot of creations and redemptions in single country funds, such as those tracking the CAC 40, DAX, FTSE MIB and FTSE 100, usually done over a shorter time period. 

In the current low interest-rate environment, investors have moved out of government bond ETFs, while Eonia (Euro OverNight Index Average) products continue to see outflows, says Giulianini. He adds the flight to quality is slowing down, meaning fewer investors have been buying German bunds and have been returning to all countries in the eurozone. 

Giulianini also notes a trend towards different listing currencies emerging. He says: “Initially, ETFs were only really listed in euros and US dollars, for example. Now, exchanges are accommodating different currency listings, although there is still a lot of room for development.”

A decade of innovation

Over the last 10 years, Giulianini has seen a proliferation of ETF providers issuing funds to compete with the top three firms, who have had the first-to-market advantage in terms of asset gathering. He says although newer entrants to market, or those established issuers that are now further cross-listing, are attempting to gain ground, each fund needs a significant amount of assets under management in order to be profitable. He adds: “Issuers can keep a fund open for maybe two years, with just proprietary seed capital, but then they need to find real client money or are obliged to close or merge funds.”

With the growing number of ETFs, there are many that are listed on the same benchmark indices. “There are, on average, around five different ETFs on the same index,” says Giulianini. “This means liquidity is fragmented, but this is the nature of the market, so we can’t complain – everyone is launching and pushing to gather assets.” 

Nonetheless, in order for the market to further prosper, Giulianini says there needs to be more clarity on industry developments. While he welcomes recent proposals by the Committee of European Securities Regulators (Cesr) on consolidated tape, whereby all trading of ETFs on and off-exchange would be reported, Giulianini says there needs to be greater detail on some of the technical points. For example, some investors may only be able to trade in two or three venues and each venue can have different settlement processes, with different pricing. 

Despite this, Giulianini says the move by Cesr is a great development. At present, only the London Stock Exchange (LSE) and SIX Swiss Exchange have mandatory reporting of ETF trades. Under LSE rules, executions in ETFs and exchange-traded commodities (ETCs) admitted to trading in London, involving at least one exchange-member firm, have to trade report to a venue. Such initiatives, as proposed by Cesr, will help reveal the true level of liquidity in the European ETF market and will, in turn, foster its growth.