Jean-Baptiste Gaudemet at Sophis explains how the growth of ETFs in Europe is spurring the use of more sophisticated technology
ETFs have recently come to the fore on a global basis, as relatively low-cost, transparent and highly liquid investment vehicles for both retail and institutional investors. Globally, ETF assets under management surpassed $1trn at the end of 2009.
These funds started life as long ago as 1989 when the first ETF was launched in Canada on the Toronto Stock Exchange. This was followed by the first ETF in the US in 1993, in the form of the SPDR tracking the Standard & Poor’s 500 index. Today, each of the leading product providers now offers a full range of ETFs, which cover the main global indices as well as a growing number of niche, themed and specialist indices such as those covering technology or new energy.
ETF trading in Europe remains fairly fragmented compared to the US, with less than half of trading taking place on exchanges, while bilateral over-the-counter deals take precedence. In the US, trading in ETFs on exchanges is estimated to have been running at $70bn a day by the end of 2009, compared with just over $3bn a day in Europe.
Since 2000, ETFs have been available to UK investors. By March 2010 there were more than 400 listed on the London market. Trading in ETFs on the London market rose by 52% in May 2010 on 2009 levels, and by 44% on the previous month. The rise was driven by new investors entering the ETF arena and by volatility in the FTSE 100 index, which encouraged speculative investment. With high profile European asset managers beginning to offer a wider range of ETFs, the stage is set for high growth in the ETF marketplace.
Challenges in managing ETFs
Despite the benefits offered by ETFs, there are significant challenges associated with managing the funds. The first is caused by the real time nature of exchange market making: there is a need to react quickly to market movements in order to avoid arbitrage, and to identify eventual arbitrage on the market.
The second challenge results from managing cross-border ETFs. There is a requirement to price and hedge ETFs with proxy bids depending on the trading hours of a specific fund and its underlying exchanges.
These challenges mean that highly efficient processes are needed to manage the higher trading frequencies of ETFs and to ensure that data is processed and updated on a constant basis. As a result, ETF providers require a stable, secure and scalable technology platform to support all of the processes that surround ETF trading.
Our experience shows that some institutions are using outdated technology platforms to manage ETF trading. Yet the variable nature of ETFs means that standard systems and spreadsheets struggle to cope.
Banks and third parties increasingly recognise that they need to manage ETF trading using systems that can cope with highly complex and fast-changing conditions including front-to-back-office management of cross-border trades, trade life cycle events, risk reporting and collateral/credit risk management.
Technology platforms need to be flexible enough to be able to adapt to changes in products and prices regularly, provide the reporting information that investors need and gear up as ETFs enter new areas of investment.
The adoption of ETF trading in Europe is unlikely to slow over the next year or two and financial institutions are to gain a lot from it. However it will be vital to have the right systems and processes in place to manage these instruments if financial institutions are to avoid the significant implications of not balancing the books.
Jean-Baptiste is product manager, investment banking at Sophis and is responsible for developing product strategy for Sophis Risque. He joined the firm in 2004 and headed up the consulting team in London for a number of years before returning to Paris to join the product management team.
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