By Simon Barriball, Head of ETP Trading Europe at ITG.
Simon Barriball, Head of ETP Trading Europe at ITG.
What’s in a name? For European ETFs, a lot of confusion
The name should say it all “Exchange Traded Fund”. You would reasonably expect that a fund describing itself as an Exchange Traded Fund would do just that – trade on exchange. The reality in Europe is quite different. Best estimates of European trading are that 50-70% of all ETF trading is off exchange on an OTC basis. One could therefore argue that ETFs fail to live up to their name.
We should ask why this is and does it really matter?
The Why?
The US and the European ETF markets are quite different. The US market is broadly characterised by a high level of on-exchange liquidity with ETFs accounting for approximately 30% of total equity market turnover. US ETFs are listed in a single currency, covered by one set of regulations and cleared in a single depository. In addition ETF usage is predominantly a retail tool with retail turnover accounting for as much as 70% of turnover. The European picture is quite different. ETFs are typically listed on multiple exchanges, sometimes in more than one currency and settled across the different domestic settlement systems of each market. ETFs are generally an institutional tool with institutional activity accounting for as much as 70% of trading. The structure in Europe creates a highly fragmented liquidity pool where it is costly and time consuming to move inventory from one settlement depository to another. This creates wider spreads and a lack of on-screen liquidity. This lack of liquidity drives dealers to source block liquidity away from the exchange via an OTC broker.
Does it really matter?
Does it actually matter if trading is predominantly OTC? One could argue with ETFs on-exchange liquidity matters less as ultimately ETFs are as liquid as the underlying assets within the ETF. This is an over simplistic view.
A lack of on-exchange liquidity is a significant barrier to trading. Currently, regulators do not require details of ETF trades to be reported although the LSE does demand that member firms report trades and MiFID II will rightly make this standard practice. This lack of trade reporting creates a lack of price discovery and transparency, as a significant part of ETF traded volume goes unreported. This lack of on-exchange volume and transparency is a significant barrier to investor engagement. Retail investors are unlikely to be aware of the workings of the OTC market and even institutional investors are put off using ETFs as the lack of price transparency makes it a significant challenge to understand trading costs. The end result is that a lack of on-exchange liquidity is holding back the growth of the European ETF market.
The Reality of Trading
ETF underlying liquidity is important when considering the ease with which one can trade an ETF on an OTC basis; however, all available liquidity sources should be considered. We can break the liquidity of an ETF down to three sources. Secondary market on-screen liquidity, secondary OTC liquidity from market makers and primary market liquidity via the ETF creation and redemption process. When choosing to trade, it is important that all of these sources of liquidity are considered.
If exchange liquidity is significant, such as with the iShares Core FTSE 100 (ISF), which trades around $65m a day, it is important to exploit that on-exchange liquidity as, over time, on-exchange trading is likely to prove less costly. If on-exchange liquidity is insufficient or lacking, other options should be considered and this is when sourcing an OTC price or tapping into the primary market is of greatest value. The need to access OTC liquidity has driven uptake from institutional investors in the use of Request For Quote (RFQ) systems. It is certainly true that RFQ systems have made life far easier to trade on an OTC basis and are also crucial for dealers in demonstrating best execution via a competitive quote. There is, however, some evidence that the ease of use of these systems is having an unintended impact on exchange liquidity as traders become over reliant on the RFQ process for all ETF orders. The LSE had total order book value traded in the year to the end of June 2016 of £46bn up 13% year on year. While total on-exchange traded volumes (including OTC reported trades) increased to £179.2bn, up by 36%. A RFQ offers immediacy of execution but this comes at a price in the same way that any principal trading does. As soon as a dealer selects to go down the RFQ route they also have no chance of matching against natural liquidity which they would via an algo trade. It is essential that dealers apply the same disciplines to ETF trading that they would to equity trading and consider all of the liquidity options available.
How to Achieve Best execution
In order to achieve best execution a trader needs to have considered all the trading options but crucially they also need to ensure that the tools and brokers they interact with are fit for purpose. ETF trading is not the same as equity trading. A trader needs to be able to determine the on-exchange liquidity and understand the cost-benefit trade-off of looking to execute immediately via a RFQ, consider trading vs NAV or other worked benchmark on a primary create/redeem or consider alternative strategies such as sourcing an ETF price via a broker working the ETF vs Futures. Either a trader has the tools available to them to make an informed decision around these options or they source guidance from the market. It is important to source un-conflicted advice where a counterpart can evaluate the options.
When the options have been evaluated it is also important that a trader has the right trading tools and counterparts at their disposal. Access to on-exchange trading is required via broker algos, access to a RFQ System that can connect to your chosen brokers and a broking list that is fit for purpose. The broking list may well differ significantly from the broking list for equities.
The need for OTC pricing means that the broking list must give access to all of the key liquidity in the OTC market. Traditional investment banks would typically be the point of contact for equity trading. In the ETF market the investment banks have increasingly become less significant in ETF liquidity provision. ETF OTC trading is capital intensive and capital constraints on investment banks post the financial crisis have resulted in them playing a less significant part in providing the ultimate source of liquidity.
Increasingly, liquidity provision is coming from non-bank proprietary trading firms. In order to source best pricing it is essential a dealer can interact with these crucial and increasingly dominant liquidity providers.
The future for ETF trading
Regulation and innovation will both play a part in the future of European ETF trading. MiFID II will require the trade reporting of OTC ETF transactions and introduce a consolidated tape. This will enhance trading transparency and will help with the uptake of ETFs as an asset class as the extent of trading liquidity and trading activity becomes more transparent. It will not as some suggest directly improve on exchange liquidity in itself. The development of the International Central Securities Depository (ICSD) settlement model pioneered by iShares and SPDR in Europe, enables all ETF country listings to share a common settlement depository via Euroclear or Clearstream. The ICSD model will improve the ease at which different lines can be funded for settlement and will help to enable greater on-exchange liquidity provision.
As ETF holders become more aware of the extra income potential of lending ETFs we should see more availability in the European market improving liquidity provision on and off exchange and helping to tighten spreads (less than 5% of ETFs are used for lending in Europe vs 25-30% in the US). Development of exchange trading facilities, RFQ offerings and specialist broker liquidity tools will continue to evolve trading and the available options. All of these factors will play a part over time in increasing the share of on-exchange trading. It will become increasingly vital to have access to all the tools and crucially the right broking relationships that can provide un-conflicted advice and analysis, access to multiple sources of liquidity be it on-exchange via broker algos, OTC via an RFQ or via new alternative sources of liquidity.
So, in some respects, ETFs do fail to live up to their name. The simple idea of funds traded like equities has developed into a European market characterised by fragmented liquidity, price opacity and a challenge in achieving best execution. No wonder the uptake of ETFs by investors in Europe lags behind the US. As such, those trading in the European ETF markets need to think carefully about their strategy and processes.
ITG is an independent broker and financial technology provider that partners with global traders and portfolio managers throughout the investment process, from investment decision through settlement.