Bradley Kay at Morningstar discusses liquidity issues in the European ETF markets and how greater on-exchange trading will lower costs
ETFs can be a bit of a misnomer in the European market. Exchange-listed, absolutely. Exchange-traded? Only sometimes. Estimates of over-the-counter (OTC) trading as a percentage of all European ETF turnover range from 50% all the way up to 80%. Without any post-trade reporting requirements for ETFs, we cannot have much greater certainty of the total volumes traded each day. All we truly know is that on-exchange liquidity of most European ETFs far lags their American counterparts.
This lag in liquidity is mostly a consequence of the different nature of the European market. Large institutional investors such as pension funds and private wealth managers represent the vast majority of ETF assets. These investors specialise in asset management and allocation, rather than trading, turn over their assets slowly, and move vast sums at a time. For a market composed of such large investors who are still mostly buying into ETFs, as seen from rapidly growing assets, OTC trading through market making arbitrageurs is only sensible rather than trying to move outside their area of expertise and work huge trades through the relatively small order books on exchanges.
Market fragmentation across Europe does not help liquidity either. Most investors prefer their local exchanges for easier settlement and lower commissions. However, this ends up segmenting exchange liquidity across the continent as natural buyers and sellers are split among not only the several national exchanges, but also among the numerous products tracking identical indices. No wonder the best execution comes from market makers who can issue shares at a very modest premium to cover their risk until the end-of-day creation rather than other investors on the exchange.
Exchange liquidity and trading volume have a classic “chicken and the egg” problem. Without a critical mass of market participants trading on the exchange, transaction costs would be too high for any new investor to buy through the exchange. That pushes new investors toward OTC trading, keeps on-exchange volumes low, and in turn pushes future market entrants toward OTC trading rather than the exchanges. The current large, low-turnover institutional investors will not break this cycle, but a new round of retail investors and institutional speculators are likely to put the “exchange” back into exchange-traded funds.
Rapid-trading institutional investors such as hedge funds have a natural use for ETFs to either hedge out market risk in their investments or take speculative bets on particular beta exposures. These firms also wish to keep large positions fairly secret and have poured immense resources into their own trading infrastructure; they prefer to route orders directly through an exchange rather than leave large block trades in the hands of a market maker. As hedge funds begin to embrace the low cost, simplicity, and far greater beta array offered by ETFs relative to futures and swaps, this will drive substantial volume on to European exchanges.
One provider in particular has led the charge to bring in hedge fund investors, drive exchange-based liquidity and lower trading costs for everyone. Source made a conscious decision to list their ETFs on only a single exchange in order to consolidate volume. They also actively courted hedge fund clients, especially through create-to-lend programmes that enable easy shorting of ETFs across the continent. The incredibly rapid growth of trading volume on Source’s limited line-up speaks for itself, and their Stoxx 600 sector funds have already become some of the most liquid and cheapest to trade ETFs in Europe.
Other providers should make similar efforts to increase exchange liquidity if they would like to see gains from an eventual inflow of retail investment. Industry representatives and pundits have constantly emphasized the importance of total cost of ownership with ETFs, and the need to account for trading costs. Advisers have taken this to heart, and will be looking for the ETFs that combine the lowest trading costs with the lowest management fees. Slow-trading large institutions will remain happy with OTC trade execution, but they will become a smaller and smaller slice of industry assets in the coming years.
This welcome move toward greater exchange trading and deeper liquidity will help lower costs for nearly all investors. However, it will also change the structure and players of the European ETF market in a way that could indirectly lead to instabilities such as the May 6 “flash crash” in the US. As the pool of ETF investors grows, and more natural buyers and sellers come together on exchanges, the spreads eventually become so tiny that traditional market makers have little room for profitable trading. Much of the liquidity provision in the US currently comes from algorithmic trading systems that seek to exploit tick-by-tick fluctuations in value rather than arbitrage the ETF price versus its underlying holdings.
Unfortunately, these trading algorithms tend to step away in times of acute market volatility. What we saw on May 6 in the US was that, when the trading bots stepped away, no market makers concerned with fundamental prices were able to take their place fast enough. Dozens of ETFs instantaneously collapsed as stop-loss market sell orders could not find any bids aside from ludicrously low stub quotes. The carnage only lasted a few minutes before human traders saw the money to be made and bids started pouring in, but cancelled trades and unreasonably cheap sales locked in losses for a number of investors hit in that period. Perhaps circuit breakers on ETFs like those at the London Stock Exchange would prevent any similar carnage. It will be difficult to know until investigators get a better idea of what precisely caused the widespread trading problems on May 6. What we can know for sure is that exchanges, providers, and market makers should prepare now for the eventual transformation of trading in the European ETF market.
Bradley is European ETF research director at Morningstar. Prior to this role, which he assumed in 2005, he was an ETF analyst covering broad market and alternative investment ETFs. He also served as an equity analyst covering the healthcare sector and worked as a data analyst in Morningstar’s data services group.
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