Amid the blistering pace of exchange-traded product launches in 2012, a subtle undercurrent of skepticism began to creep into the market for new issues.
As fund sponsors offered up more esoteric products, tracking lesser-known indexes or even featuring active management, the enthusiasm and participation of the vibrant trading community around mainstream index ETPs failed to show up.
With little interest and low average daily volume, market makers had very little reason to maintain tight spreads or display large quotes for many new (and old) ETPs. The demand wasn't there. Record launches resulted in record closures.
For most investors, an ETP is only as good as it trades. While the ETP's adviser is responsible for keeping an index ETP's net asset value in line with the underlying index, the market itself keeps the ETP price from moving too far to a premium or discount to the NAV. Similarly, an ETP with thin trading, regardless of how well the adviser tracks the underlying index, can show significant bid-ask spreads as market makers manage the risk of holding a low-trading product by making more when it does trade.
Institutional investors, transacting primarily with authorized participants to create shares of an ETP, are often safe from these multiple layers of pricing pitfalls. For less-than-creation size orders, however, ETP sponsors and exchanges have been contemplating solutions to improve trading metrics and attract both investors and market makers.
In early 2012, BATS Global Markets, Lenexa, Kan., introduced its Competitive Liquidity Provider program for quoting in BATS BZX exchange-listed ETPs. Designed to attract new listings and transfers, the CLP program provides market makers a daily $250 in quoting incentives, $125 each on the bid and ask, split between the top two liquidity providers.
Only two issuers have listed with BATS in more than a year of the program, BlackRock (BLK)'s iShares unit with 16 funds and ProShares with two funds, even though BATS' two exchanges cross nearly 16% of average daily dollar trade volume of all U.S.-listed ETPs, according to research firm XTF Inc., New York. According to BATS, about 10 different market-making firms participate in the CLP program each day.
Last year, the Nasdaq Stock Market, a unit of Nasdaq OMX, New York, and NYSE Arca, a unit of NYSE Euronext, New York, both sent proposals for new ETP market-making programs to the U.S. Securities and Exchange Commission. Each had their own twists, but both approached payment for market making more explicitly than the BATS quoting program.
While active in other countries, payment for market making has been banned by the Financial Industry Regulatory Authority since 1997. Updated proposals from securities exchanges, however, compelled FINRA to reconsider certain aspects of Rule 5250 on payments for market making.
SEC's green light
Nasdaq's proposal, known as the Market Quality Program, was the first to get the green light from the SEC and is expected launch imminently. Nasdaq is home to just 98 ETPs, or 6.7%, of the 1,458 listed exchange-traded funds, notes and commodity pools, but its exchanges cross 19% of all U.S.-listed ETP average daily dollar volume. For those ETPs, currently seven different market-making firms are designated liquidity providers.
MQP participation is set for a one-year pilot in which ETP issuers would pay Nasdaq $50,000 per enrolled product that would, in turn, be paid to securities market-makers for meeting predetermined quoting and trading goals. The issuer could goose the offer with a supplemental fee up to an additional $50,000. Once an ETP hit 1 million shares traded per day — currently the provenance of 111 products listed across all three exchanges — it would be out of the MQP.
Following Nasdaq's approval from the SEC, FINRA filed to alter 5250. Comments are due to the SEC by May 15, the same day the rule is to be implemented.
David LaValle, vice president of transaction services and head of ETP listings for Nasdaq OMX, said the program helps solve the chicken-egg problem between ETP issuers and market makers, whereby issuers attempt to promote new or small funds but investors interested in less-than-creation size units don't see the products as having sufficient liquidity.
Conversely, market makers argue that they will show up when demand arises, as long as there is ample underlying liquidity in the fund's holdings.
Nasdaq has also undertaken separate ETP-related initiatives, attempting to convert its third exchange, Nasdaq PSX, to an ETP-trading destination and proposing ETP orders based on intraday net asset value.
The SEC's comment period for the latest market-making proposal from NYSE — the NYSE Arca ETP Incentive Program — closes on May 2. Arca, which holds the lion's share of ETP listings, is looking to attract lead market makers for products lacking an LMM as well as enhance the obligations and requirements for LMMs to funds trading less than 1 million shares a day. The fund or the issuer would pay an optional fee between $10,000 and $40,000 annually for no more than five existing funds per issuer in a one-year pilot program. All newly listed funds, once the program is accepted, would be eligible as well.
In the current system, Arca's 15 lead market makers are offered greater rebate incentives for their position, but they have no true franchise to protect and are vulnerable to more opportunistic or aggressive market makers under no obligations.
Mapping out arguments
Both market-making firms and ETP issuers have spent the past several months mapping out their arguments for participating in the proposed programs. Issuers are evaluating the extent to which the added cost of enrollment would benefit them indirectly through increased assets in the funds. Market makers are evaluating whether the bounty would be worth the cost of inventory and trading risk.
Damon Walvoord, head of ETF capital markets for market-maker Susquehanna International Group in Bala Cynwyd, Pa., points out that these proposed programs are only designed to increase “on-screen liquidity,” accessible through the public markets as displayed quotes — resting bids and offers — on exchanges and ECNs
“We don't expect that the new incentive programs would offer significant impact or improvement to block-size liquidity, which is already quite ample,” said Mr. Walvoord, whose firm is the LMM for 215 Arca-listed ETPs.
In comment letters last year, the Investment Company Institute and large issuers State Street Global Advisors and BlackRock (BLK) were generally positive on programs designed to “promote market quality and efficiency,” while The Vanguard Group was more concerned about the impact on ETF shareholders as issuers would likely “seek to recoup those costs in some way from the ETF and its shareholders.”
Through a spokesman, Vanguard, which lists 17 of its 65 ETFs on Nasdaq, said its concerns voiced in the initial comment letters haven't changed.
David Abner, head of capital markets for New York-based WisdomTree Asset Management, a unit of WisdomTree Investments, said the company will evaluate the programs and determine “if the funds and investors will benefit.”
In some cases, such liquidity training wheels might be superfluous. Occasionally, long-listed dormant ETPs suddenly become popular — attracting assets and trading — as their particular theme or investing style catches on. WisdomTree's Japan Hedged Equity Fund is a recent example.
Trading in the fund has increased 15-fold year-over-year in response to aggressive monetary policy in Japan. Net flows into the fund stand at $5.3 billion over that time period, more than all but three other ETPs.
“Anytime you are increasing costs for small ETF sponsors without a direct correlation to asset growth, you put startups and innovation at a disadvantage,” said Noah Hamman, CEO of Bethesda, Md.-based AdvisorShares Investments, which sponsors 18 actively managed ETFs with $805 million in assets under management.
Market leader iShares, by contrast, boasts more than $600 billion in ETP assets under management in the U.S. alone. Still, Joseph Cavatoni, managing director for iShares capital markets, Americas, at BlackRock in New York, said there has to be “demand in the product” and that “market-making alone does not make for success.”
This article originally appeared in the April 29, 2013 print issue as, "Programs popping up to attract investors and market makers".