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.

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