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.

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