Seeing is believing: the virtuous cycle of trading transparency

Trading visibility, or the lack of it, is one of the ETF industry’s biggest challenges. With over-the-counter (OTC) trading on the rise in Europe, the true depth of liquidity is increasingly hidden, dampening confidence among investors and hindering asset growth.

With MiFID II expected to address non-reporting of OTC trades and efforts underway to aggregate European trading data, a solution is in sight, but will undoubtedly be a complex and lengthy process. As OTC trading continues to dominate an increasingly fragmented market, solving the transparency problem will only grow in importance.

According to BlackRock, between 2010 and 2011, European reported OTC trading rocketed nearly 500%, representing a growing proportion of total volume (30% in 2011 versus 7% in 2010). The OTC market, however, is notoriously opaque and experts estimate only a third of trades are actually reported, meaning OTC is far more dominant than those figures suggest. “The centre of gravity has not changed," says Michael John Lytle, Managing Director at Source. "From a pure on-exchange liquidity perspective, we are in the same place as a year ago with total daily turnover around the $3bn mark.”

However, total liquidity is actually estimated at between $6bn and $9bn, which, if properly understood, would boost investor confidence and therefore trading volumes. According to Koei Imai, Nikko Asset Management’s Head of ETFs in Japan, where over 70% of daily volumes trade OTC: “Investors who only refer to on-screen information may reasonably assume the market is small, with potentially low liquidity.  However, this is a misconception as only 11% of the market was represented on-screen in March 2011 based on average daily volume. The misconception regarding the true nature of ETF liquidity continues to act as a barrier to both retail and institutional investment.”

Increased visibility

By increasing visibility, those barriers break down feeding a virtuous cycle of liquidity as increased assets and lower costs from greater competition generate further trading, adding to the overall market attractiveness and efficiency. (Fig 1).

As Keshava Shastry, Director of iShares Capital Markets, explains: “Trading visibility is a self-fulfilling prophesy. As more volume becomes visible, potential clients who were put off as there didn’t appear to be enough liquidity, gain the confidence to trade. Increased turnover attracts more market makers, which typically leads to more competitive pricing and spreads collapse. In turn, tighter spreads have the desired effect of generating increased trading, feeding back into the virtuous cycle.”

European sector ETFs clearly exemplify the effectiveness of this virtuous cycle. In July 2009, total monthly turnover of European sector ETFs traded on Deutsche Boerse was just under €2bn. At that time, Source launched a suite of products concentrated on one exchange, avoiding the need for market makers to fragment their trading capital. As Figure 2 below demonstrates, the result was a massive increase in total monthly volumes of sector ETFs, peaking at nearly €16bn in February 2011. Interestingly, the growth has focussed on Source’s ETFs, which accounted for nearly 80% of the roughly €9bn traded in April. Competing products have remained largely stable around €2bn. The number of market makers for Source’s products has increased from six at launch to 26 and, on the back of high trading volumes, the average spread on the Source European Banks sector ETF tightened five basis points in 2010 to 0.16% and has seen a further four basis-point decrease year-to-date.

Efforts are already underway to boost overall ETF trading visibility by increasing the proportion of OTC trades reported, but also to aggregate trading data across Europe to help minimise the impact of fragmentation. ETFs do not fall within the current MiFID definition of "shares admitted to trading on a Regulated Market" so are not subject to its transparency regime. As a result, there is no formal reporting mechanism for most European OTC trading. In the case of Xetra, the leading trading venue in the EMEA region accounting for 33% of total average daily on-exchange volumes and 34% of total assets, OTC post-trade reporting is voluntary. “As ETF trade reporting is not a requirement in Europe, and for many brokers requires a bit more work, many therefore do not,” explains Deborah Fuhr, Blackrock's Global Head of ETF research and implementation strategy. “Many institutions are not aware that they can and should ask brokers to report their ETF trades.  Most investors want to see their trades reported, with the exception of some hedge funds, who prefer their activity remain anonymous.”

Hedge fund participation

As potentially significant contributors to ETF volumes, high-velocity hedge funds are a crucial component in the industry’s growth. Their participation has remained relatively low in Europe versus the US because of lack of on-exchange volumes. As a result, many providers are trying to drive more volume onto the exchanges while also actively courting liquidity-hungry hedge funds. Educating market participants that voluntary reporting is predominantly in their own interests will be critical. iShares already actively encourages post-trade reporting, which Shastry says is improving. He believes a significant proportion of the 500% growth in European OTC trading is attributable to greater reporting levels rather than actual trading growth.

MiFID II is widely expected to extend the equity transparency rules set out in MiFID to ETFs, including a requirement to report OTC activity. The European Fund and Asset Management Association (EFAMA) are keen supporters of extending equity transparency to ETFs under MiFID II, but are also spearheading initiatives to create a Europe-wide consolidated ETF trading tape. "Once MiFID II has put the obligation of post-trade reporting in place, then that can be imposed at the local level on all market participants," says Graziella Marras, Policy Director at EFAMA.

"A consolidation of ETF trading data would be very beneficial for the ETF industry as it would show greater liquidity, which is particularly important for institutional investors, who are the dominant European market players. “However," Marras warns, "It is important to understand that this only applies to true ETFs and it is therefore important that the definition of what constitutes a true ETF be correct in the MiFID II regulations. We are concerned that the Commission does not currently provide a definition and the one used by its advisory group, the Committee of European Securities Regulation, would catch many more funds."

Voluntary transparency?

Given the need for further clarification and the lack of a clear time line for its implementation, the greater visibility demanded by MiFID II is still some way off. While it is possible local exchanges may move to increase transparency voluntarily in the meantime, driven by pressure from ETF providers, current approaches to OTC trade reporting are as fragmented as the ETF market itself and are unlikely to see much development until there is greater clarity on the specifics of MiFID II.
Even once reporting mechanisms are in place, OTC trading data itself is unreliable.

According to a Deutsche Boerse spokesperson: “OTC data lacks granularity in terms of types of trading, timestamps, and over- and underreporting.  In addition, OTC data needs to be standardized. Once quality improvement and standardization have been achieved the data can reliably be aggregated together with exchange data and displayed to the public by commercial vendors. We are confident that ETFs will fall under the transparency regime of MiFID II. As soon as this happens the existing consolidators will be able to provide a consolidated tape for ETFs without a problem.”

Even if MiFID II and the subsequent aggregation of European ETF data takes time, educational efforts are already paying off and, in combination, will likely provide a significant leg-up for growth of ETF trading and assets. According to Lytle: “It is not a problem of getting trades done. It is a problem of publicising them. Greater visibility would present a huge opportunity. European ETF assets have grown despite lack of transparency, but if you throw this into the equation, Europe has the potential to grow much more like the US and double the ETF AUM in a shorter time span.”

However, while these initiatives solve the problem of transparency, they do nothing to address the underlying problem of market fragmentation. In fact, by following the current trend of spreading their product range across jurisdictions, currencies and exchanges, ETF providers are increasing the scale of the transparency problem, effectively shooting themselves in the foot. “The dominance of the OTC market in Europe is a combination of two key factors,” says Ben Johnson, Morningstar’s Director of European ETF Research. “Firstly, we are seeing a continuation of fragmentation with multi-listings for the same products, meaning . Some providers have been disciplined to foster liquidity, but most have not.”

By extension, brokers making markets on-exchange have to fragment their trading capital across those different markets, directly impacting the depth of liquidity.
“Secondly,” Johnson continues, “European ETF activity is dominated by institutions, who demand a higher level of hand-holding and larger trading sizes.” Until a clear and uniform post-trade reporting system is in place, the need for greater visibility of OTC trading through voluntary reporting becomes more desperate in order that a growing percentage of ETF liquidity is not hidden from sight.