Global ETF Advisors principal Richard Keary discusses the proliferation of the European ETF market and regulatory developments that will spur further growth
Years ago, global banks built worldwide networks so non-US based institutions had access to the US markets. While they actively bought and sold securities in the US for their clients’ portfolios, they also helped to make the US markets the most liquid in the world. But what happens when these institutions suddenly find a new source of liquidity in Europe, rather than the US?
We began to see this happen just before the financial crisis hit. London was raising more capital than New York, while the Asian markets were keeping more initial public offerings (IPOs) on the local markets as they were able to find more domestic capital. These developments did not evolve because the US was losing its competitiveness; rather, they stemmed from the growth and maturation of other international markets. These same market dynamics are now occurring in the European ETF arena.
ETFs began trading in Europe in 1999, six years after being launched in the US. The European market is now showing signs of a major growth spurt. According to Barclays Global Investors’ ETF landscape report, there are more ETFs trading in Europe than in the US. As of July 2009, the year-to-date growth rate for assets under management in European ETFs is 28% compared to 17% in the US. The rising ETF activity in Europe is bolstered by an increase in funds coming to market and the faster pace of economic recovery compared to the US.
If the ETF industry is committed to these ideals of transparency and access then they must unite and lobby the European Commission to ensure that ETFs are included in Mifid II
However, in terms of regulatory environment, market structure and investor demand for products, Europe is in the initial stages. Nonetheless, regulatory changes are now emerging, which highlight the growth potential in the region. The maturation process occurring will also enhance liquidity and bring investors to Europe that might have otherwise flocked to the US to fill their larger order flow. The opportunities that the proposed regulatory changes present will be the true mechanism for growth in the European ETF market.
Understanding the implications of regulatory change will assist product issuers and service providers in determining how much investment they should make in the ETF markets outside of the US.
There are two key rule changes being drafted in Europe through the European Commission, which include the second Markets in Financial Instruments Directive (Mifid) and Undertaking for Collective Investments in Transferable Securities (Ucits) IV. Mifid is a set of rules for trading securities and Ucits is a set of rules for funds. These new rule changes are expected to be written and approved in 2010 and will most likely be implemented in 2011.
ETFs were not included in the first Mifid directive and therefore by rule ETF trades do not have to be reported to an exchange. Around 60%-70% of ETF volumes in Europe are traded in upstairs over the counter (OTC) markets, meaning these are not seen by investors. Some of the discussions around Mifid II centre on creating a consolidated tape, which requires trade execution reporting and dissemination from all EU exchanges. This would allow for a clearer definition of best execution to emerge in European equity trading similar to what already exists in the US. It would also reduce fragmentation through technology, as new trade reporting systems would need to be implemented, which would help provide true transparency of equity pricing information for investors.
As the European Commission begins the process of creating Mifid II, there is a chance ETFs are left out again. The rumblings heard are that if the European Commission is going to include ETFs, it should look at all financial products, such as various derivatives. Given the current demand for ETFs there is no reason why ETF investors should be denied a truly transparent and accessible market.
If the ETF industry is committed to these ideals of transparency and access then they must unite and lobby the European Commission to ensure that ETFs are included in Mifid II. The industry must also ensure this is not delayed because of false association with certain derivative products.
As with all proposed rule changes, there may be various industry participants that will prosper under new rules and those that will not. The market participant that has the most to gain from these new rules is the individual and institutional investor. They are best served by creating a market place that is transparent and accessible for all.
The European Commission has already paved the way for approval of Ucits IV. The proposal includes a management company passport, which will allow funds managed in one member state to be remotely managed in another member state. It allows for the removal of various barriers for cross-border distribution and use of a master-feeder structure, enabling funds to be easily merged.
These new rules should reduce ETF providers’ cost structure and make the funds more fungible. This could lead the industry towards a global ETF platform as Ucits programmes are already recognised in markets in Asia, the Middle East and Latin America. Since the US regulators continue to be reluctant to accept Ucits funds there is the possibility that growth in the ETF industry could have a greater affect on markets outside the US and a shift of some assets could occur.
The combination of Ucits IV and Mifid II encompassing ETFs would create a more significant retail market in Europe. These new regulations will define best execution, provide transparency and create a process that allows funds and capital to flow freely throughout the EU, while helping to build a more liquid marketplace.
As a result, institutions would be able to locate pools of liquidity in local markets rather than have to come to the US to buy and sell in large quantities.
The European exchanges are currently spending a lot of money on technology upgrades or acquisitions, increasing the likelihood of more algorithmic and arbitrage trading as seen in the US. As the liquidity pool in Europe deepens, institutions in Germany, UK and the Nordics, which represent the largest European participants in ETFs, may discover some advantages to buying ETFs on their local markets. We have already seen more products come to market in Europe than the US, can trading volumes and assets under management be far behind?
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