ETFs: building liquidity

ETFM asks a panel of experts to discuss the role of market makers in the ETF arena

What is the role of the market maker and why is it so important for ETFs?

Mark Rodino: The market makers are responsible for placing bids and offers on the exchange to provide on-screen liquidity and facilitate clients’ buy and sell executions. This ability to trade intraday is the key advantage of ETFs  versus their mutual fund cousins. Market makers keep the ETF trading prices efficient, true to net asset value (NAV) and make buying and selling these funds easy for clients.

Paolo Giulianini: A market maker is an operator whose primary task is to ensure the quality of the market and the liquidity of the listed instruments.

It is a broker-dealer firm - usually an investment bank - that assumes the risk of holding a certain number of units of an ETF in order to ease the process of trading of this instrument on the exchanges where it is listed or on the over-the-counter market. 

The market maker has the role of keeping the continuous tradability of ETFs. Official market makers – and according to each exchange they could be called ‘permanent liquidity provider’, ‘designated sponsor’ or ‘specialist’ – have committed legally “vis-à-vis” the exchange to make markets in the ETF. They do this by posting binding bid and ask prices throughout the trading day, even when underlying markets are closed.

True market makers are looking for the fastest and cheapest way to hedge trades done on their quotes posted on exchanges, create ETF units and maximize ETF trading capabilities.

The market maker has the inalienable responsibility for dealing in ETFs and making liquidity available in the market. 

Since 2000 UniCredit has been the pioneer in market making for ETFs. With a team of more than 20 ETF traders, sales people and advisors based in three different locations comprising London, Munich and Milan, they continually trade ETFs as official market maker on nine different European stock exchanges, covering both Western and Eastern Europe.

Nick Ramsbotham: Winterflood Securities is one of the leading market makers or liquidity providers in London, making markets in more UK stocks than any other firm, according to the London Stock Exchange. Our team of over 70 traders brings a wealth of experience and commitment to market making, offering brokers, asset managers and institutional investors over 10,000 tradable instruments including UK, European and North American equities together with investment trusts, ETFs, gilts and bonds.

We provide low latency integrated electronic trading platforms that allow for immediate access to our internal liquidity in all sectors, with dedicated sales trading services for managed orders and FIX order routing directly to exchange order books and MTFs.

For the retail investor we have many brokers that connect to us electronically enabling them to trade cheaply and efficiently for their clients, often at a better price than shown on the London Stock Exchange.  Institutions with larger orders can contact our specialist sales traders or market makers directly to take advantage of our liquidity provision and keen prices. 

Market makers are significant within the ETF segment because they bring valuable liquidity; Winterflood makes markets in virtually all UK listed products, also covering the leading EU and US stocks, most of which are available electronically. We have a dedicated team of traders that specialize in these securities.   

Henry Reece: Market makers facilitate trading by buying (or selling) shares from (or to) investors. At Susquehanna International Securities, we do this by providing continuous bid-ask quotes to the exchanges for investors to trade against and by trading commission-free with clients over the phone for larger orders. We are members of all major exchanges and make markets across equity, fixed income and commodity ETFs.

ETFs track a hugely diverse array of indices. We furnish prices throughout the trading day, regardless of whether the markets of the underlying securities are open or closed. This means that an investor can, for example, trade an ETF that tracks the MSCI Brazil index in the European morning, before the Brazilian market is open, and can at the same time trade an ETF tracking an Asian index after the Asian markets have closed. 

Our extensive market making activities give us a wealth of experience in the manner in which ETFs trade. We can use this experience to give investors insights into current market conditions, including volatility, the state of the spreads and whether those spreads are likely to be tighter at a different time of day.  Likewise, if an order is large, we can comment on potential market impact and describe various trading strategies that can be used when executing an ETF order. Ultimately, this is all information that can save the investor money.  

In summary, the role of a market maker is to provide competitive bid-ask spreads on-exchange, to provide clients with liquidity for larger trades over the phone and to assist investors in accessing the best liquidity.

Why is liquidity so important? Is it integral to keep a tight bid-ask spread?

Nick Ramsbotham: We believe it is important that liquidity is made available both on and off the exchange order books. When dealing with Winterflood liquidity can be accessed in different ways, we can offer clients two alternatives. Firstly clients can take advantage of our ability and appetite to make risk prices and trade with us away from the order book but within the rules and regulations of the London Stock Exchange (LSE) at prices equal or better than that obtainable on the underlying exchange order books. Secondly, through our low latency electronic trading platforms we offer the ability to interact with the exchange order book which is known as Direct Market Access (DMA). This is classified as trading on exchange and on order book. 

Liquidity, and therefore the bid-ask spread, is dependent on the underlying ETF. So for example an ETF trading in the Eurostoxx 50 will have a much tighter bid ask than one in, say, Vietnam due to the underlying stocks enjoying a much higher level of liquidity. Liquidity will always feed through to create tighter bid-ask spreads which in turn helps everyone enabling trading in large amounts of stock at tight prices. Tight bid-ask spread are beneficial to the investor as it enables the client to trade much closer to the net asset value (NAV) of the ETF. 

Henry Reece: Liquidity is extremely important as investors need to know they can trade at a competitive price and that they can get in and out of large positions when required.

A key feature of ETFs is that they can offer far greater liquidity than is initially visible from their trading volumes. This is for two reasons:

Firstly, an estimated 80% of ETF trading volumes are unpublished. Under current Mifid legislation, there is no obligation to report off-exchange trades. Accordingly, the real trading volumes of ETFs are presently vastly understated.

Secondly, due to their open-ended structure, it is possible to create and redeem shares in an ETF by buying or selling the shares in the underlying index. This effectively means that the liquidity in an ETF will mirror the liquidity in the index that it tracks. So when assessing the liquidity of an ETF one should consider the liquidity of the underlying securities, not just the ETF.

To give an example: the London listing of the iShares Eurostoxx 50 ETF, has an ADV of 175,000 shares (approximately £4.5m). We have generally been able to trade £10m on the touch in one clip, which is twice the ADV on a 12bp wide market. So the liquidity in ETFs is certainly there, though it is not always visible.

Bid-ask spreads are important because they are a visible way ETFs can demonstrate liquidity. Asset managers look closely at spreads when assessing trading costs and liquidity risk. Retail investors also are increasingly looking for tight bid-ask spreads.

The spreads on ETFs have tightened considerably in the last 18 months.  For example, ETFs tracking the FTSE 100, CAC 40 and DAX indices currently trade around 4bps wide. In ETFs tracking MSCI emerging markets, where we are particularly active, we have generally been able to make a market 15bps wide for up to $20m. Fixed income products are also trading significantly tighter – in many cases, tighter then the spreads in the underlying bonds themselves.

Paolo Giulianini: The liquidity of an ETF could be roughly evaluated by looking at two different factors: the number of shares available in the marketplace, both in the buying and selling sides; and the bid-ask spread, which is the difference between simultaneous quotes for prices at which exchange-listed products can be purchased and sold.

Market makers ensure the liquidity of ETFs by continually quoting bid and ask prices while the exchange is open. Their role is to provide real-time pricing, as well as to keep the bid-ask spread tight, thus bringing volume to the product. ETF market makers instantly lock in their profits through arbitrage, rather than risking exposure on either side of the market. Doing so, the relationship between the underlying market and the ETF is always kept in line with the fair value. The interplay between market makers’ quotes and customer orders ensures a high degree of liquidity in the ETF market.

There is a range of ways UniCredit can make it easier for investors to trade ETFs. Firstly, we are able to trade ETFs in a number of different currencies, including EUR, GBP, USD, CHF, AUD and CAD, among others. If a customer has a large trade to execute, we are usually able to offer more liquidity than is available on the exchange taking into account the depth of the book.

Mark Rodino: Liquidity facilitates the buying and selling of securities on-exchange. The more liquidity there is, the easier it is to trade and therefore, the better for clients. Off-exchange liquidity, or ‘over-the-counter’ trading is equally important for larger trades.The bid-ask spread is essentially how the market maker ‘gets paid’ for providing liquidity to clients on the exchange. For clients, tight, consistent bid-ask spreads make these products cheap and efficient to trade.

Usually the size of a spread is an indication of how difficult it is to trade the underlying basket of securities, in other words the market marker will experience higher risk, therefore needs to build this into the spread. If clients place an order on the exchange we advise them to work it with a limit, or speak to us for an OTC quote for larger trades.

What is the difference between market maker and authorised participant?

Mark Rodino: Market makers are responsible for placing bids and offers on the exchange to provide on-screen liquidity and facilitate clients’ buy and sell executions. The authorised participants (APs) can create and redeem additional units in the ETFs. APs require a signed agreement with the ETF provider to achieve this status. This creation/redemption functionality is due to the open-ended structure of ETFs, and means that funds always trade close to their NAV when the underlying market is open; but more importantly, it means that clients can easily access the deeper liquidity pools available in the underlying basket of shares via an AP if needed.

Paolo Giulianini: It is necessary to make a distinction between the primary and the secondary markets within ETF trading activity. 

The liquidity of an ETF is generated in two ways: one is through daily trading on the secondary markets, which all kinds of investors can access; the other method, perhaps more important, relies on the so-called creation-redemption process that is carried out in the primary market where only authorised participants have access.

Authorised participants are thus firms that have signed binding agreements with ETF issuers in order to exchange perfect baskets of securities and create/redeem ETF units in large sizes.

Market makers quote bid and ask prices on the secondary market. Usually they are called liquidity providers and they do not have obligations regarding quantity of ETF units to offer and bid-ask spreads to maintain. Furthermore there is also a particular class of official market makers, called ‘specialist’, ‘designated sponsor’ or ‘permanent liquidity provider’. They can access the primary market like the other liquidity providers already mentioned, but are also subject to several requirements in the secondary market quoting. These include a maximum bid-ask spread in the prices offered; minimum requirements in terms of quote quantities; and minimum times for refreshing quotes.

Only official market makers are supervised in their role by stock exchanges where they would play the specialist role. UniCredit, for example, has signed a binding agreement with more than nine European exchanges in order to be official market maker for the listed ETFs.

Henry Reece: We are both a market maker and an Authorised Participant (AP).

Market makers trade on exchange and over the phone with clients. APs transact with the ETF issuer itself in order to create or redeem shares in ETFs. As ETFs are open-ended funds, an AP can create or redeem shares by delivering to the issuer the exact basket of shares in the underlying index and receiving ETF shares in return.

As a market maker, we use our AP status to efficiently manage our trading book, creating shares to deliver to clients or redeeming shares we have bought. This also enables us to trade ETFs based on the official, daily published NAV.

Nick Ramsbotham: Winterflood is a market maker in a wide range of ETFs. We add liquidity intraday to the market both on and off the order book allowing clients to trade the underlying security on a real time basis. Under the rules of the LSE being a market maker we can choose to hold stock or go short in anticipation of client order flow in a certain product. 

An AP will actually break or create the underlying ETF with the provider or issuer after market hours. This is typically for larger orders.

What issues do market makers have to deal with? 

Paolo Giulianini: The ETF market behaves as a quote –driven market more than an order-driven market. This means that it is less the buy and sell orders entered by investors than the official authorized market makers that ensure liquidity for ETFs. 

Only official market makers are given a “bona fide” hedging and shorting exemption, meaning they are exempt from limits on speculative positions and shorting stocks for example, in order to keep the markets moving in a fair and orderly way. Lead market makers stand ready to buy and sell their assigned products on a continuous basis. As a perfect tracker of the underlying index, an ETF’s liquidity is particularly reliant upon the liquidity of the securities that are included in the basket of the underlying index. 

The more liquid those components are, the more efficiently the market maker can hedge its position and hence post better and tighter quotes in the market.

Furthermore it is interesting also to underline that the market maker deposits its inventory of ETF units at different Central Securities Depositary Houses, which are different in the UK, France, Germany, Italy, Switzerland, Netherlands, Spain, and across Europe, in order to avoid operational failures during the settlement of the ETF trades.

The activity of ETF lending is the area that will see the most interest in the near future. We have acted in the create to lend market for many years and now investors are embracing ETF lending and borrowing, as this is the only way to get real short exposure to the market for a longer period, something that short ETFs can not guarantee.

Nick Ramsbotham: One of our biggest issues is cross-listing across exchanges as this can cause a great deal of confusion within our client base. Cross-listing will also dilute the publishing of volume across the tapes or venues giving unrealistic and confusing trading data on a particular product. This also leads to many settlement issues as the clients find it difficult to determine the different listing arrangements. All of these issues increase overheads which is unfortunate when one of the main advantages of using an ETF over a collective is cost. We continue to work with settlement agencies, providers and exchanges to find an effective solution to cross-listing.

Mark Rodino: When the same ETF is cross-listed on different exchanges and in different currencies, this creates more work for market makers. For example, our HSBC S&P500 ETF is listed in both GBP and USD on the LSE and cross-listed on the local German exchange – Deutsche Boerse – in EUR. This means the market makers will be watching that they trade in line with each other and with the NAV of the fund. If they trade out of line, the market makers will start arbitraging these differences, which brings the prices back in line with the underlying basket of stocks tracked by the ETF. 

Henry Reece: As ETFs are fungible, multiple listings are not an issue – we can simply re-register the shares from one exchange to another. This allows investors to trade in the currency and on the exchange of their choice. We can usually offer the same liquidity across all the listings, matching the liquidity in the main listing, so cross-listings should not disadvantage the investor.

The lending market for ETFs has developed greatly in the last two years which helps us make tighter spreads. It is clearly in everyone’s interest that the lending market continues to develop.

Biographies

Paolo is director and head of ETF Trading and Market Making at UniCredit. He runs a well established and successful team based in London, Munich and Milan. Prior to joining UniCredit in 2007, Paolo was head of Delta one in Banca IMI for 14 years, where he started trading ETFs when launched in Europe.

Nick joined Winterflood Securities in August 2000 having previously worked at Donaldson, Lufkin & Jenrette in London as a specialist trader in North American securities. Nick started trading ETFs and ETCs at their early introduction to Europe in 2004 and has subsequently become head of ETF and ETC Trading at Winterflood Securities.   

Henry joined SIG in 2007, working on the commodities desk where he was responsible for the precious metal ETF trading. In 2009 he joined the team that oversees the ETF market making strategies across equity, fixed income and commodity ETFs, and is currently responsible for building and maintaining client relationships

Mark is head of ETF Sales for Europe, Middle East and Africa (EMEA). He joined HSBC in May 2010, and is helping the bank launch its suite of HSBC -branded ETFs and also build out of a pure-play ETF trading platform. Prior to joining HSBC, Mark was head of ETF sales for Europe at Knight Capital.