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By Adriano Pace, head of the ETF marketplace at Tradeweb.
In recent years, exchange-traded funds (ETFs) have seen consistent growth in assets. Institutional investors in Europe carry out their trades both over-the-counter (OTC) and on exchanges, while the introduction of electronic request-for-quote (RFQ) trading has increased transparency and improved access to liquidity for the European ETF market.
In the US, ETFs and exchange-traded products (ETPs) are well-established investment vehicles, with combined assets now totalling US$1,641 billion, according to 31st October 2013 figures released by ETFGI. Most trading takes place on exchanges by retail and institutional investors alike.
In the relatively nascent European market, assets have steadily increased in recent years, but at around US$408 billion (ETFGI, 31st October 2013) the potential for further growth remains high.
The majority of ETF investment in Europe is by institutional investors, who are seeking low-cost exposure to a diversified range of underlying assets including equities, fixed income, commodities and/or property. Regulatory initiatives such as the UK’s Retail Distribution Review (RDR), in force as of January 2013, are also expected to drive business towards ETFs.
A fragmented picture
There are, however, unique challenges to the European environment that may be limiting its growth. The market in Europe is, perhaps unsurprisingly, highly fragmented, with several currencies in use and 24 exchanges offering ETF trading (compared with three in the US). These factors help to explain much of how the European market has developed: many products are denominated in more than one currency and listed on multiple exchanges. As a result, although there are around 2,000 European ETFs and ETPs, the number of listings totals more than 6,000.
One consequence of this is a high degree of fragmentation in on-exchange liquidity, and liquidity providers need to generate and update bids and offers for each listing simultaneously (or as close to it as possible). To contain their risk should the market price move before they have had time to adjust all their quotes, dealers typically limit the size in which they make public markets in ETFs. Exchange-based trading, therefore, is only part of the answer in Europe.
It is estimated that around two-thirds of trading volume is carried out over-the-counter, which makes it difficult for investors in European-listed ETFs to obtain the visibility they need about the liquidity of the products they wish to trade, and to get a full picture of overall trading activity. This is likely to drive a significant portion of the OTC market to electronic platforms, where the typically larger trades can be carried out in an effective and recorded manner: from price discovery, through execution, to processing and reporting.
The value of electronification in OTC trading
The market as a whole is driven by a search for liquidity, a need for efficiency, and the need to satisfy all aspects of a more highly regulated environment. Traditionally, OTC execution has been conducted by phone or chat, but this is increasingly inefficient and time consuming – and brings the risk that the market moves between quotes from different dealers. In addition, in an asset class where multiple listings mean that many instruments have similar names, it has proved all too possible to trade the wrong listing with many ramifications, including trade processing and settlement problems.
Upcoming regulation is also a factor – the broad nature of likely MiFID II requirements suggests that ETFs will need to adapt to these rules in future, putting a greater onus on institutional investors to prove “best execution”. Reporting the relevant data from phone calls or chat logs will be laborious and will make it difficult to verify that the best price was achieved.
Venues that aggregate liquidity in one place while providing greater efficiency and a mechanism for recording trade data, like Tradeweb, will satisfy many of these concerns. On multi-dealer electronic venues, institutional investors can request prices for the entire size required from several liquidity providers simultaneously, thereby achieving greater pre-trade price transparency.
Electronic trading platforms have developed technology that aims to enhance trade execution workflow. For example, Tradeweb functionality provides precise identification to avoid confusion over which ETF is being traded, and can also alert investors selecting anything other than the best price. Meanwhile, connections to risk and order management systems reduce manual inputting errors while facilitating trade processing.
A suite of post-trade reporting tools, such as access to audit trails that log data from each request-for-quote, the ability to generate customised reporting and analysis, and compliance reports that can assist in proving “best execution” are also typically available on electronic marketplaces.
Another key benefit, particularly for the overall ETF market, is the newfound ability for institutional investors to trade in size in a way that is recorded. This facilitates confidence in the depth of the market and improves perceptions of the market’s liquidity.
Addressing the issues of market fragmentation, lack of transparency and illiquidity perception should help the ETF market to fulfil its potential in Europe – increasing volumes and daily flow. This will be a positive and long anticipated development for all participants in the European-listed ETF market.
Tradeweb is a world leader in building and operating electronic over-the-counter marketplaces. Founded in 1998, the company is headquartered in New York with various offices around the world including in London, Singapore, Hong Kong and Tokyo. In October 2012, the company launched an electronic marketplace for trading European-listed ETFs, through its regulated multilateral trading facility operator Tradeweb Europe. For more information about this marketplace, visit: http://www.tradeweb.com/Institutional/ETFs/.