All too often, exchange-traded products are described as mutual funds that trade like stocks. A closer look reveals that not to be the case. To the surprise of many, ETP traders are comfortable in the dark.
To counter this trend and bring more transactions back to "lit' markets, securities exchanges have designed programs to encourage trading in new products and attract fresh listings. So far, ETP issuers have hardly nibbled at the offerings, and market makers have their doubts.
While significant attention has been paid to high-frequency trading, internalization and dark pools for equity securities, “hidden” stock trading, as deemed by the U.S. Securities and Exchange Commission, is only roughly 17% of stock volume.
For exchange-traded products, however, the share of ETP trading off exchange has risen to 34% of average daily share volume, up from 26% in 2011, according to data compiled by XTF Inc. This shift also coincides with a greater cancel/trade ratio for ETPs relative to stocks, according to SEC market structure data. Moreover, many of the largest, most liquid and well-known products consistently trade significant share volume away from securities exchanges.
Much of this shift is embedded in the nature of ETP trading and liquidity.
Institutional investors and large registered investment advisers are looking for tighter and tighter trading spreads at greater and greater size. Yet, across the matrix of exchanges and other venues for trading, a hodge-podge of order types and routing instructions face investors and brokers. According to some participants, this web of venues is direct fallout from the SEC Regulation NMS, designed to improve price and transparency mostly for equity investors.
With this in mind, Bloomberg Tradebook, the agency brokerage business of Bloomberg LP, launched in June an anonymous request for quote service to help investors find large block ETP liquidity.
“This anonymous request for quote platform gives investors a better way to find liquidity, given the current ETP volume found off-exchange,” said Sabrina Gagliotta, global head of trading and execution consulting at Bloomberg Tradebook in New York. “Two-sided quotes minimize information leakage while allowing buyers and sellers direct access to market makers,” she said.
In four months, the number of ETPs requested rose to 71 products from 35, and the number of firms using the platform to find ETP liquidity increased fourfold to 35.
As in equities, ETP market makers play a critical role in maintaining orderly trading by displaying quotes within certain parameters for size and spread. Over the last few years, each of the three ETP listing exchanges — NYSE Arca, Nasdaq Stock Market and BATS — has introduced programs to encourage more competitive ETP quoting. These programs focus largely on either newly listed products or a test subset of an issuer's existing offerings. Uptake has been limited.
For example, BATS offered a higher rebate for serving as a lead market maker for smaller products when it debuted as a listing exchange in 2012. Of the 63 ETP issuers, only four have listed new funds with BATS. As another example of issuer hesitance to try new options, an NYSE Arca pilot program to compensate market makers for more, tighter quoting was available for over a year with no participation — even as 204 new ETFs came to market in the past 12 months.
It wasn't used until early October when ProShares, which manages $26 billion in ETP assets, listed the ProShares Managed Futures Strategy (FUTS) on NYSE Arca and signed up for the incentive program. Jane Street Trading will serve as the lead market maker for FUTS under the new incentive program.
A similar pilot program at Nasdaq was announced last year and the exchange is evaluating how to provide additional support to market makers, according to a spokesman.
BATS offers a “competitive liquidity provider” program that offers market makers daily cash rewards for meeting specific criteria. On BATS, three ETF issuers are currently participating in the program with four market makers. In mid-October, BATS also eliminated listing fees — paid by the fund — to encourage issuers to invest in the program, which is paid for by the fund manager.
“We are very supportive of programs that bring about a more competitive market structure,” said Steve Sachs, head of capital markets for ProShares in Bethesda, Md. “It takes time, but regulation always catches up to the market.”
But market makers, too, have to be convinced.
“The role of lead market maker in the way that issuers want or need costs a lot more and is worth a lot more than the current state of incentive programs,” said Damon Walvoord, head of ETF capital markets at Susquehanna Investment Group in Bala Cynwyd, Pa. SIG is the lead market maker for 281 of the 1,641 U.S.-listed ETPs.
