Seeing is believing: ETFs and transparency

Emma Cusworth looks at the virtuous cycle of ETF transparency and looks at what the introduction of MiFID II will bring to the market

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 it 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.”

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. (See chart 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.”