In my last post, we introduced you to the who of the ETF ecosystem. We defined the various types of market makers (MMs) and other market participants, and explained what role each plays in the everyday trading of ETFs.

Today we are going to discuss why these players are in the ETF ecosystem – how their business models differ and what motivation they each have for trading ETFs.

Why is this important? Simply put, the interaction between these different market players can lead to liquidity for the investing public. Furthermore, any of the recent discussions around regulatory changes for market makers – for example, their obligations within the marketplace – must start with the strategies these firms employ. This understanding may also help dispel fears around a potential breakdown in trading leading to illiquid markets in ETF securities.

Of the many market participants, there are 2 main categories which facilitate ETF trading on a daily basis: Authorized Participants and Market Makers. The visual below explains how each interacts with ETFs on a regular basis.

Authorized Participants (APs)

On the primary market side, Authorized Participants provide a service by transacting with an ETF sponsor to manage the supply and demand of ETF shares in the marketplace.  Some APs will create and redeem new shares to manage their own inventory, while those who do not engage in market making simply facilitate creations and redemptions on behalf of their clients (which could include market makers).  Even the concept of ‘create to lend’ – creating new shares in order to lend them to a short seller– is simply another example of client facilitation.

Market Makers (MMs)

What incentive do market makers have for making two-sided markets – and therefore providing liquidity – in ETFs?  We see a couple of different business models in the MM space.

The first are firms that seek to take advantage of possible arbitrage opportunities between their own calculated ‘fair value’ and the price of the ETF in the secondary market. Arbitrage refers to the simultaneous purchase and sale of an asset in order to profit from a difference in the price.

If, for example, an ETF’s secondary market price is higher than the fair value a MM has calculated for that ETF, the MM will sell the ETF, purchase a correlated security as their hedge such as the underlying basket of securities, and then utilize an AP to create the ETF to cover their short position.  As we discussed earlier, the market maker and AP could be the same firm.  Often these price discrepancies are quite small and can disappear almost instantly.  In fact, one of the main reasons ETFs typically trade so close to their underlying value is because of the quantity of firms that use this type of strategy.

Now, approximating an ETF’s fair value is not an exact science – especially for US listed ETFs with international underlying securities since foreign markets can be closed when US markets are open.  These firms do take a risk when utilizing an arbitrage strategy.  The MMs calculate this value based off of a number of factors – it can be as simple as pricing the ETF off of the underlying basket or as complicated as adjusting via the performance of correlated securities.

The second MM business model we see are firms that trade ETFs in the same way that they would trade any equity, like PG or MSFT.  This group looks to capture the bid/ask spread as well as rebates from the exchange’s maker/taker pricing model.  The bid/ask spread is fairly self-explanatory – if MMs can buy on the bid and sell on the offer, then they will make the difference after any associated transaction fees.  The maker/taker pricing model is where stock exchanges pay rebates to those who provide liquidity and charge a fee for those who take the liquidity.  If a market making firm can make more liquidity then they take, they will receive more in rebates from the exchange then they would pay in fees.  This type of activity is more common in highly liquid ETFs.

As you can see, each market participant in the ETF trading ecosystem has a different business model when it comes to trading ETFs, and all are interacting to provide the liquid markets that the public has come to expect.

The one main driver for success in any of the above market making models is trading volume.  But what happens for new and less liquid products that have low trading volume?  We will conclude this series with a discussion as to why this is an issue and the steps the exchanges are taking to solve it.

David Mann is head of regulatory affairs for iShares.

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