Asset owners could pay price in ETP exchange wars

The battle among the three main U.S. stock exchanges for volume and issuance of exchange-traded products has meant lower costs for issuers and market makers, but asset owners using ETPs should take note that such competition could impact best execution and heighten volatility.

ETPs are issued on a single exchange but can trade on the secondary market across several venues both on and off exchanges. Both listing and trading business is being actively courted by Intercontinental Exchange Inc.'s NYSE Arca, the Nasdaq Stock Market and BATS Global Markets Inc. and has spurred a number of incentives from all three to attract more market share, both for issuance and for trading volume. In the latest moves, BATS on Oct. 1 introduced ETF Marketplace, which offers to pay issuers as much as $400,000 a year to list ETPs on its exchange, with payments based on average daily volume. That same day, NYSE Arca reduced fees for issuers and added price incentives for lead market makers. Nasdaq instituted its own lead market-maker incentive program in July.

The money for these incentives is more than recouped by the increased volume on the exchanges, sources said.

“If (money managers) are compelled to use a venue because of their rebate, are they getting best execution?” asked Michael Falk, partner at Focus Consulting Group, a Long Grove, Ill.-based consultant to money managers. “And ultimately, since it's their investments that are being traded, is that exchange offering them what they need as a fiduciary? ... In all contracts (with money managers), there's always the same line requiring best execution. There's a duty to the client — but how does the client verify that it's being practiced? As a result, money managers must act to check any impropriety in selection of venues.”

These incentives have come at a time of concern over how ETPs impact overall markets. Mary Jo White, chairwoman of the Securities and Exchange Commission, said last month the agency is looking at how ETPs behaved Aug. 24, when markets lost more than 3% of their value as many ETPs traded at a sharp discount from their net asset value. Trading in more than 1,000 ETFs was halted because of automatic volatility limits.

The competition is particularly heated for trading on the secondary market. As of Oct. 29, according to data on ETP analytics firm XTF Inc.'s website, BATS and its affiliated exchanges had 26% of total U.S. trading volume, with 22% for NYSE Arca and 15.2% for Nasdaq and its affiliated venues; the remainder is traded at smaller exchanges or over the counter. In listings, NYSE Arca is the clear leader, with 87% of total U.S. listings year to date Sept. 3, the latest data available, vs. 11% for Nasdaq and 2% for BATS.

While sources lauded the benefits of ETP venue competition, Mr. Falk — though not criticizing the exchanges for the efforts — wondered if it's “hard (for exchanges) to serve more than one master” with the drive for more revenue vs. the responsibility for providing a venue with best execution. “There's a potential for conflict,” he said. “I'm not saying there is conflict, but do we even want to go there? All these incentives are geared to drive up volume, and ultimately drive up (exchanges') earnings. All I'm saying is, is that good for everyone?”

Ryan Larson, head of U.S. equity trading at RBC Global Asset Management (U.S.) Inc., Chicago, agreed that there could be a perception of a conflict with exchange incentives but that it points to a broader issue with market structure.

“Unfortunately, potential conflicts of interest are inherent in our current market structure and are a consequence of its evolution,” Mr. Larson said. “From maker-taker pricing, to exchange SRO status, to even the dissemination of market data; potential conflicts of interest are arguably embedded at most touch points throughout the life of a trade. The events of Aug. 24 highlighted several themes, among the most important, just how interconnected things are in this environment, and, the immediate need for enhanced communication and coordination amongst market participants, especially in times of extreme volatility.”

Mr. Falk also said the concerns extend beyond just ETPs to the broader market in general, as research over the last few years has shown that the growth in the number of ETPs has pushed overall market volatility higher, and that the correlation of stocks in the S&P 500 has skyrocketed with more trading moved to these liquid products. “Research points to evidence that ETFs mean higher volatility,” he said. “The problem is, people are doubting that because they think we're at a time of low volatility. But there are two types of volatility — absolute, which is what the market is seeing now, and temporal, which are volatility spikes. I believe we're exposing ourselves to frequent volatility spikes, or spikes that may be more severe.”

Bryan Harkins, executive vice president, head of U.S. markets for BATS, New York, said he understands why investors could be concerned, spurred by events such as Aug. 24's ETF debacle. “Black-swan events define how people view these products and, frankly, they can spook people,” Mr. Harkins said, adding that worry leads to concerns about best execution and the potential for conflicts. “There's a perception issue we have to be sensitive to,” he said.

Jeff McCarthy, vice president and head of exchange-traded product listings and services at Nasdaq, New York, said incentive programs can serve as an added bonus to best execution. “Institutional investors can benefit from market-maker trading incentives if such programs are structured to promote best price,” Mr. McCarthy said. “ETPs have an ecosystem that consists of both primary and secondary markets; therefore, it is important to construct programs that balance the ecosystem while protecting investors.”

On the primary market, Mr. McCarthy said ETP issuers should consider “a multitude of factors when selecting the best primary listing venue for their products,” including its market structure, infrastructure and depth of liquidity.

Steve Crutchfield, vice president for options markets, exchange-traded products and bonds at the New York Stock Exchange, New York, said issuers are mostly concerned with bringing the best product they can to investors, which makes selecting a venue so important.

“I've never heard of an issuer choosing an exchange based on an incentive rather than based on the experience of their customers,” Mr. Crutchfield said. “As for market makers, those conversations have been about costs and rebates driving order routing or liquidity. That's been around for many years. Brokers have policies and procedures to be able to trade in volume. Market makers are deciding where to trade based on order flow.”

ETF issuers such as State Street Global Advisors, which issues and manages the SPDR series of exchange-traded funds, are paying close attention to the venues they use, said Timothy Coyne, New York-based head of SSgA's ETF capital markets group. SSgA issues and trades on all three main exchanges as well as smaller venues. Mr. Coyne said that low cost is important, but as an issuer, the firm looks deeper when choosing a venue, including which exchange provides the best overall value to issue an ETP.

“On the surface, competition is good, and higher trading volumes spur that competition,” Mr. Coyne said. “So for us, we're objective in looking at our listings and think about lead market-maker selection. We understand that the actual trading is an essential component of our (ETP) business.”

BATS' Mr. Harkins said cost should just be one component when selecting an exchange. “Everyone should do due diligence on places like BATS to determine what the technology is like; is it robust?” Mr. Harkins said. “When competitors have an outage, that opens up the competition for others. Second, look at the quality of liquidity, the types of participants who are trading. And also the rules of the exchange. They should understand how ETPs are handled. The cost is secondary, the icing on the cake.” n