MiFID set to boost liquidity in the European ETF market
To achieve greater levels of dealing and underlying liquidity levels, the ETF market in Europe needs to overcome some structural problems.
It is not the gift the ETF industry was hoping for. Just as thoughts turned to celebrating ten years since ETFs were first introduced in Europe, the Swiss-based Financial Stability Board issued a report that raised some awkward questions for the ETF industry to address.
The FSB report appears to focus on the financial stability implications of swap-based ETFs in cases of extreme market environments. The concerns centre around the problem that affects all fast-growing sectors: the trend towards ever-increasing sophistication which, for the ETF market, means removing the sector from the original justification of the ETF as a simple, transparent and cheap form of investing assets.
Dan Draper, head of ETFs at Credit Suisse, downplayed the FSB report’s findings, saying that concerns over whether ETFs could fuel market instability in extreme market conditions were misplaced. He agrees that in the short term, in niche markets, an influx of money through ETFs may send valuations away from values justified by fundamentals.
“If you start applying ETFs to certain markets with relatively low levels of liquidity, you potentially attract new types of investors and speculators,” he says. “As you bring more in, in the short to medium term you have the possibility to encourage herd behaviour. But in areas such as the S&P 500, with huge capitalisation in the underlying market, I would argue that the ETFs’ impact is positive in terms of price discovery and liquidity.”
The liquidity factor
A key factor in the quality of an ETF is the link between the dealing liquidity (continuous, daily and weekly), and the liquidity of the underlying investment. Farley Thomas, global head of wealth solutions and ETFs at HSBC, says: “The lack of the link in some traditional mutual funds created problems for investors during the credit crisis. For example, investors in property funds with daily dealing liquidity and little investment liquidity caused the fund managers to suspend dealing.”
With ETFs, there is continuous dealing liquidity as a result of the exchange listing and the requirement for market makers to always offer retail dealing liquidity, albeit with varying spreads, Thomas says. “This should give investors – particularly retail investors dealing in smaller sizes – comfort, since there is no similar dealing liquidity commitment available with traditional mutual funds.”
Liquidity is of critical importance to an ETF, says Keshava Shastry, director of the iShares capital markets team.
“An investor needs an ETF to be liquid in order to be able to trade in and out very quickly, while keeping the execution cost at minimum.”
The importance of liquidity is why iShares operates an open architecture multi-dealer model with a dedicated capital markets team, says Shastry. “While the former guarantees that there are more than 30 Authorised Participants who can create and redeem units in iShares ETFs, the latter makes it easier for clients to make the optimal use of the model and its benefits while achieving best execution when implementing their ETF trades.”
A comparison between the US and European ETF markets illustrates the importance of liquidity to the ETF market. Michael John Lytle, managing director of Source, says: “Over the past few years, US hedge funds have become some of the largest users of ETFs – they trade in size and often represent more than 30% of daily turnover on US exchanges. The opposite is true in Europe, where many large institutions are waiting for on-exchange liquidity to reach US levels. There are several factors that weigh against increased on-exchange liquidity in the European market in its current form, and most of them revolve around fragmentation.”