Nicholas Pratt looks at the role asset services can play to help struggling exchange-traded funds reach sufficient liquidity.
Selling services to exchange-traded fund (ETF) providers has been a steady source of income for custodians over the last decade as would be expected from a market that was estimated to be worth more than $1.59 trillion (€1.21 trillion) earlier this year, according to Deutsche Bank Markets Research. But in recent years many ETFs have struggled to reach a sustainable level of liquidity.
In the US, the monthly ‘deathwatch’ list, compiled by mutual fund adviser Ron Rowland, of ETFs that are more than six months old and with an average daily traded value below $100,000, continues to increase. In October 2012, it stood at 394 from an eligible universe of 1,465, an increase of 17% from June’s 336, which was itself an increase of 127% on the 148 names that appeared on the list in June 2011.
Consequently, a number of asset servicers have been reviewing their offerings in a bid to encourage more sustainable levels of liquidity among existing ETFs and a continued growth in new ETF launches. “For five or six years we have been looking at how we can leverage our other businesses to support ETF providers,” says Tony O’Brien, head of ETF sales, Europe, Middle East and Africa, BNY Mellon Asset Servicing.
One way is to act as a match-maker capable of bringing different communities together. For example, in the US market where ETFs attract more retail investors, BNY Mellon has used its broker dealer subsidiary Pershing to push ETFs to the individual retirement account (IRA) communities. In Europe, where ETF investors are more institutional than retail, and access to the market comes from authorised participants (APs) and market makers.
“It is important to use the relationships with APs when a client needs help launching an ETF. We want to see the ETF providers grow so we advise them on the state of the market and remind them that intermediaries such as the APs are also stakeholders in the ETF, it is not just the investors,” says O’Brien. “We have also developed an AP interface, which is a way for them to get directly to the fund and undergo the creation/redemption process on an automated level.”
The main liquidity challenge for ETFs is ensuring that the product creation and distribution works effectively, says Liam Butler, Northern Trust’s head of ETF fund administration in Europe. “It is not hard to launch an ETF but for it to make economic sense for the issuer, you have to get scale.”
Butler says that this match-making ability will become more important for prospective ETF issuers. For example, an asset manager that wants to get into the ETF market but does not have an ETF infrastructure may be able to partner with an existing ETF provider that is willing to work with a third party manager and use their investment expertise. “There is a cost to becoming an ETF provider and it might not make sense for every prospective ETF issuer to develop a full ETF infrastructure from the outset.”
For new ETF launches, asset managers need a distribution capability, especially with multi-listed ETFs that could be on more than ten exchanges. But liquidity is not the be all and end all for ETFs in Europe, says Robert Rushe, head of ETF servicing at State Street. “It is not like in the US yet, where on-exchange liquidity is everything. An efficient creation and redemption process is the best way to limit the spread.”
Rushe does agree that there is some value in an AP relationship-management service. “It is about making sure that the APs are happy with the ETF. The more confidence the APs have in the ETF, the less risk premium they add to the spread and this helps liquidity.”
The phenomenon of asset servicers launching a raft of new services designed specifically to help new ETF issuers find sustainable levels of liquidity does not appear to have made it to the European market yet.
Match-making and AP-relationship-management services are typically aimed at new and inexperienced ETF issuers, rather than the handful of established ETF providers that already have well developed AP relationships.
O’Brien says the fact that the top three ETF providers dominate the European ETF market makes it all the more necessary for asset servicers to offer any potential newcomers more assistance. “Any new ETF has to have either a new strategy or a new distribution channel. Therefore it is incumbent on us to work with them and offer them a suitable business model to turn their concepts into reality.”
While it is likely that asset servicers will look to develop their match-making abilities, the idea of offering a full, one-stop suite of services from seed capital to settlement aimed specifically at new ETF issuers is unlikely to be a prominent feature in the European ETF market. “We need to be realistic about what a one-stop shop delivers as providers might be delving into the areas where they might not have expertise,” says Butler.
Instead it is likely that custodians will focus their efforts on trying to solve two issues that affect all participants in the ETF market – settlement and securities lending. Settlement is one of the most inefficient areas in the European ETF market, especially with multi-listed ETFs, says State Street’s Rushe.
“There are sub-custody networks and multiple credit default swaps involved depending on where the funds are domiciled and it can be an operational minefield and very costly to move ETF shares around. But the biggest issue is that many ETF investors do not know how to move these shares between markets.”
Even for the experienced ETF providers, settlement remains an important issue. In Europe the settlement systems are said to be fragmented and expensive, at least compared to the US.
A tighter settlement process could also kickstart the relatively inactive securities lending market for ETFs. “Collateral management is one area where custodians can play a more central role by providing more transparency and reports on the underlying assets,” says O’Brien. “The securities lending market has changed but it is still important, especially for swap-based ETFs, and our ability to act as an agent and not a principle makes the product much safer.”
©2012 funds europe