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Regulation

Europe in line for ETF boom, thanks to MiFID II

Investor interest expected to explode due to new data on trading, liquidity

J.P. Morgan Asset Management’s Bryon Lake

The dark clouds hanging over the money management industry from new trading and transparency rules in Europe could prove to have a silver lining for exchange-traded funds providers.

The Markets in Financial Instruments Directive II, which became effective Jan. 3, imposes reporting, transparency and best execution requirements on financial instruments. ETFs, which were not included in the original MiFID rules, are subject to this latest iteration and, as such, details on over-the-counter ETFs trades will have to be reported for the first time.

Sources expect this to be a boon for ETF players, with an expectation that institutional investor takeup of the investment vehicle — which has been somewhat muted in Europe vs. the U.S. — will potentially explode once these investors are able to see the levels of trading and liquidity related to these funds.

"We expect that indeed MiFID (II) will spur quite a lot of interest in ETFs," said Marina Cremonese, a vice president and senior analyst at Moody's Investors Service Inc. in London.

Previously, ETF trades did not ​ have to be reported in Europe, as much of the trading was on an OTC basis, so "the whole market did not have information on the trading volumes. From the moment (we get) better transparency on trading volumes and liquidity, it will likely prompt a larger usage of ETFs by institutional investors, as market depth and liquidity (are) important in their decision-making," said Ms. Cremonese.

ETFs are not subject to trading obligations, and so business might be conducted on- or off-exchange. "However, pre- and post-trade reporting rules are attached to both types of execution, while investment firms are also subject to very comprehensive record-keeping obligations," said Adriano Pace, London-based managing director for equity derivatives at Tradeweb Markets LLC. These transparency requirements will increase "visibility into European ETF market liquidity. This certainly helps investors get a fuller picture of overall trading activity, which should in turn boost their confidence in the depth of the market."

Seeing an impact already

While MiFID II has only been in place for a little over one month, market participants say they are seeing an impact already.

"Best execution and post-trade transparency are two areas where MiFID II seems to have had an impact on ETF trading," said Slawomir Rzeszotko, head of institutional sales and trading, Europe, at quantitative trading firm, global liquidity provider and market maker Jane Street Group LLC in London. "In both cases, the changes appear to have encouraged institutional investors to execute more trades via (request for quote platforms)."

Global ETF and exchange-traded products assets hit $5 trillion for the first time in January, with Europe recording a 6.7% increase from the end of 2017, according to data by ETF and ETP research firm and consultancy ETFGI LLP. The firm said in a statement accompanying its data that the change represented the greatest absolute monthly growth in European ETF and ETP assets on record.

Mr. Rzeszotko said Jane Street saw "substantial ETF flows in January," with a 70% year-on-year increase for European client business. "We'd attribute those numbers to a few contributing factors: January was a particularly active trading month, and some of this can be attributed to growth within our client business, as well as an uptick from RFQ platforms as a result of MiFID II."

And the requirement for increased transparency under MiFID II for ETFs does not have providers particularly worried.

"From an ETF perspective, net-net this is a real positive — all the things that these regulations are driving toward align very closely with what ETFs provide to the investor," said Bryon Lake, London-based international head of ETFs at J.P. Morgan Asset Management (JPM). "They are very well known for being transparent," he added. "Because of the way ETF businesses are set up and the industry has evolved, the changes that MiFID II is driving, frankly, are very low-touch to the ETF business. There is not a time we're sitting at our desks, wringing our hands, thinking, 'How do we react?' There wasn't a retooling of the business and what we needed to do."

BlackRock (BLK) Inc. (BLK) collected information related to its iShares Europe strategies and saw a spike in ETF trading volumes in January due to the new visibility afforded by MiFID II.

While January did experience a period of market volatility, with flow behavior and trading partly a function of those factors, "nonetheless we have seen a continuation in the use of ETFs as far as volumes go," said Patrick Mattar, managing director in the iShares Europe, Middle East and Africa capital markets team in London. "What we benefit from, and had hoped for, is more transparency around the OTC trading of ETFs, which previously weren't easy to recognize and weren't reported. It means we are able to look at screen-traded volumes plus OTC-traded (ETFs) to get a better picture of what the real volumes of ETFs trading are."

$50 billion jump

What executives at the firm saw was a $50 billion jump in reported ETFs traded to about $80 billion.

"It was always there but now is optically evident — that is kick-starting renewed interest" in ETFs, using them in new ways beyond simply for access to asset classes, said Mr. Mattar.

In January, investment bank Citigroup, Inc. said it had added ETFs to the list of instruments it accepts as collateral in agency securities lending transactions, citing MiFID II as one of the drivers. In an announcement, Citi said the ETF market "is still a relatively untapped source of collateral that can enable investors to access further liquidity and improve collateral efficiency, while minimizing counterparty risk through index diversification."

Said Mr. Mattar, "When volumes and trading hit a certain critical point, the acceptability of any of those things that trade as collateral becomes more feasible." The look-through liquidity afforded by the MiFID II rules means "we're at a tipping point where ETFs themselves are being recognized increasingly as something that can be used in the world of lending. It means the borrow market in ETFs in Europe is moving toward where it is in the States," he said.

A good "borrow" or securities lending market also lends itself to a "functional options market," Mr. Mattar added.

"What we've seen for the first time in European ETF trading is really a concerted interest in trading ETF options in Europe. A load of clients use ETF options in the States, but in 2018 — and it's a culmination of MiFID II (and other factors) — I think there is an acceptance that this is now a practical and attractive proposal for people who want to trade volatility, buy protection or raise income by selling options. That's really unlocking a whole new dimension in the way end-investors can use ETFs," he said.