Which came first…the chicken or the egg? This phrase comes to mind when my team, the iShares US Capital Markets Group, is asked why some newly launched exchange traded products (ETPs) have relatively low trading volumes.
Clients are sometimes hesitant to invest in these new products because the low trading volume can translate to wide spreads and limited availability. They are understandably concerned about wider bid/ask spreads impacting their total cost of ownership, and that concerns us, too – so much so that we regularly raise this issue with the market makers.
Now, as I’ve outlined in recent blog posts, there are multiple players in the ETF trading ecosystem, and all are interacting to provide the liquid markets that the public has come to expect. But sometimes in a newer ETF, market makers can be hesitant to make tighter markets until there is clearer demand from the buying public.
They’re worried about putting more of their capital at risk for a product that does not exhibit strong trading volume. Both sides are waiting for the other to make a move, and the result can be products with low trading volumes and wide spreads. [Meet the ETF Market Makers]
This liquidity conundrum has prompted recent NASDAQ and NYSE ARCA rule proposals that aim to improve the market quality in new or less liquid exchange traded products via market maker incentives. Basically, the exchanges would like to create an ETP provider-funded “Fixed Incentive Program” in order to entice market makers to create liquidity in otherwise thinly traded ETPs. This would be particularly helpful in ensuring that investors get better execution – and the lowest trading cost – possible when trading a new ETP.
iShares is generally supportive of such incentive programs for market makers and of innovations that promote more efficient markets for ETFs – that’s why we were the first sponsors to list products on the BATS exchange, which utilizes an innovative competitive liquidity provider (CLP) program to improve market quality.
Why do the market makers need incentive? There are two main reasons. The first has to do with the role market makers have traditionally played in bringing a new ETF to market. In the days leading up to a new ETF launch, an ETF will seek out an authorized participant to “seed” the product by delivering a basket of the underlying securities to the ETF in exchange for a large block of shares of the ETF (usually around 100,000). As a reminder, an authorized participant can be a market maker itself or can be acting on behalf of a market maker.
There are real risks to seeding new ETFs. The seeding entity represents the primary initial owner of the fund, which means they are the only market participant who can sell shares to the public. If there’s not strong initial demand for the ETF, they must hold this inventory for an extended period of time, subjecting them to either the market risk of the ETF or the risk of their hedges underperforming the ETF. These positions may also have a balance sheet expense to the market maker which becomes increasingly meaningful in today’s regulatory environment.
There are also risks for some market makers after the ETF lists. If the listed exchange is NYSE Arca, a lead market maker (LMM) is chosen to maintain a market in the ETF at all times (for NASDAQ, it’s a designated liquidity provider, or DLP). It is the LMM/DLP’s capital on the line if there are any sudden market moves. And with the growing trend of volume trading off-exchange, it’s possible that a market maker is active on the screen (i.e. displaying bid and ask quotes for a particular security) but does not get the benefit of order flow execution when demand does arise.
Because of these risks, and the fact that current LMM/DLP incentives are negligible for products with low volumes, market makers are increasingly saying no to the LMM/DLP role. This concerns us greatly, as we believe the role is crucial to providing liquidity within the ETF ecosystem. Essentially, it creates a situation where investor demand may prompt ETF providers to create products to meet such investor demand, but the lack of initial trading volume may cause the bid/ask spreads to widen and increase total cost of ownership for the investor. In short, it’s a sub-par experience for the investor.
Now, demand cannot be created out of thin air simply by having a tighter spread. However, we believe it to be an unfortunate result that a client would elect not to trade an ETF solely because on-screen market quality was insufficient, and that’s why we support the exchanges taking innovative approaches towards improving the market quality of new products.
As to the differences between the two exchanges’ proposals (the SEC should rule on them within the next couple of months), we believe there may be more than one effective way to improve the markets for ETPs – we simply support the concept that exchanges should be free to explore innovative solutions to this conundrum. Because better markets can lead to better executions, resulting in a better experience for you, the investor.
David Mann is head of regulatory affairs for iShares.