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Magazine Issues » July-August 2013

ETFs: An efficient ecosystem

CoralEurope's ETF market lags behind the US in volume but attempts to make the market more efficient may hold the key to greater growth, Nicholas Pratt discovers.

The volumes in the European exchange-traded fund (ETF) market are considerably lower than in the US. Whereas the US is close to $1.3 trillion (€1 trillion) and 9.3% of the total funds industry, in Europe those figures are $300 billion and 2.9% of the funds market. A number of market participants in Europe are asking why this is the case and whether it is possible for European ETFs to gain the same share of the funds market.

A common explanation of the difference is that ETFs are traded differently in Europe. Whereas the US has one settlement body – the Depository Trust and Clearing Corporation – to handle all post-trade processes, Europe has a fragmented market with the same ETFs listed on multiple exchanges and traded across borders via a costly and complex settlement structure. In short, there is a domestic operating infrastructure supporting an international product.

In June BlackRock, the fund manager which owns the largest ETF provider iShares, and Euroclear Bank, the international central securities depositary (ICSD), moved to address the fragmented post-trade structure in Europe when they announced plans to issue a new iShares ETF that would settle via Euroclear. The scheme aimed to provide ETF investors, regardless of their location, with one settlement venue.

“ETFs are listed on multiple domestic exchanges and are increasingly being traded cross-border which has created a lot of post-trade friction and failed settlement,” says Stephan Pouyat, head of global reach product management at Euroclear. “For example, broker dealers are finding that ETF shares have to be converted for different national CSDs’ procedures and large inventory balances have to be maintained in different markets to mitigate potential liquidity risk.”

The purpose of the project is to facilitate efficient trading and reduce cost by removing the need for broker dealers to build extra inventories for settlement purposes. In addition to the creation of a more cost-effective and reliable post-trading environment, such a move may help to create a securities lending market for ETFs by establishing a more centralised pool of liquidity, says Pouyat.

The pilot programme will see the new settlement structure applied to a newly-launched ETF rather than causing any change to existing ETFs.

“We are optimistic but measured and we want to get it right,” says Leland Clemons, BlackRock’s managing director for iShares capital markets Emea. “The ultimate ambition is to transition the whole of our ETF portfolio to the ICSD infrastructure and we expect initial success may lead other ETF issuers to do the same.”

One clear target audience on the buy-side are the institutional investors that take a more proactive approach to managing their inventory for securities lending purposes. However, all investors should benefit from lower on-exchange spreads, says Clemons. For broker dealers managing multiple CSD relationships, the benefit is more obvious. The management of ETF inventories becomes easier, their costs go down, which results in tighter spreads and more competition.

The European market will need to address other issues aside from the use of a single settlement structure in order to grow the ETF market – such as the investor profile and the ease of access for those investors.

Another issue that needs to be addressed is the fact that under the current Markets in Financial Instruments Directive (MiFID), ETF trades do not need to be reported.

According to Guy Simpkin, head of business development for execution venue Bats Chi-X Europe, this is the single biggest inefficiency in the European ETF market. The lack of reporting for off-exchange ETF trading means that roughly 70% of the market is unreported. This means that market-makers are not always privy to a true picture of the ETF market. And where trades are reported, it can be misleading. For example, often both sides in a bilateral transaction can report the same trade.

MiFID II will address this point, says Simpkin. “Ahead of MiFID II there is a general consensus in the market that transparency is a good thing and that can benefit the market and trading participants are more inclined to report their ETF trades than they once were.”

He welcomes the iShares/Euroclear pilot and believes it will take a lot of operational risk out of the system but it will not change the fact that issuers will still feel the need to list on multiple exchanges. And this is where Bats Chi-X is hoping to make a difference. Owing to it multi-currency capabilities, says Simpkin, it can make ETFs available for trading on the same platform. This would reduce the risk that market makers have when posting their risk capital across several different exchanges, he adds.

Bats Chi-X Europe has recently been granted recognised investment exchange status in the UK, giving it the regulatory authority to act as either a primary or secondary venue for ETF lisintg.

“We are talking to issuers and we hope to list our first ETFs later this year,” says Simpkin. “We will be competing with national exchanges for the volume so we will have to create the order books that will attract the ‘paper’ in order to encourage investors, especially domestic investors, via their brokers, to use us in addition to their national exchanges.”

Source, a UK-based ETF provider owned by five equity trading houses including Bank of America and Goldman Sachs, has become one of the fastest growing ETF providers in Europe in its four years of operation and has achieved this partly by listing only on a select number of exchanges – originally the Deutsche Boerse but now also the London Stock Exchange and the SIX Swiss Exchange.

“When we launched we were going to list on all the major exchanges but the market makers told us not to do this,” says Michael John Lytle, chief development officer at Source.

Lytle welcomes the recent initiative from iShares and Euroclear as evidence of a desire among participants to make the European ETF market more efficient. But he sees it as a helpful rather than transformative development, not least because it is focused on reducing back-office costs rather than changing front-office behaviour.

To this end Lytle believes that moving away from trading ETFs on national exchanges and establishing a supra-exchange where investors could come together to generate liquidity for ETF issuers would be a fundamental way to make the ETF market more efficient.

However, even with these structural changes, it would be wrong to assume Europe could become exactly like the US, says Lytle. The obvious difference is there is only one currency in the US and although there is spread of ETFs across multiple exchanges almost all are listed on the NYSE. There are also much larger ETFs in the US, and in Europe there is a different investor profile with fewer retail, day traders and hedge funds trading ETFs.

Nevertheless, hopes are high within Europe that ETFs are set to become more popular with investors looking for low cost investment vehicles.

iShares global head, Mark Wiedman, says the European ETF market could reach $1 trillion in the next three to five years but only if “the entire market ecosystem becomes more efficient for investors”.  

Much depends on how Europe manages its careful balance of harmonised structure underpinned by competition – be that between different CSDs international and domestic, and also the exchanges competing for both primary and secondary listing business.

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