17 July 2019

Inside the Baskets: How ETFs Are Traded

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It’s not brain surgery, but the business of buying and selling exchange-traded funds can get complicated. And that has attracted the brains of some fancy traders to solve the problem. Daily trading of ETFs has averaged $81.5 billion so far in 2015, according to research firm XTF. But unlike stocks and bonds, whose prices are set by supply and demand, ETFs require a little more calculus on all sides for a properly functioning market.

While shares of ETFs represent a direct holding of underlying assets—just like mutual-fund shares—they can be traded all day. This creates opportunities to juggle (or arbitrage) the values of ETF shares against the values of their underlying assets, for those who have the capital to do it. And that potential for profit has attracted former derivative traders and quants to the middle of the action as market makers.

Changed game 

Key to the growth of this market, where investors have parked more than $2.1 trillion in assets, are these intermediaries, from Wall Street firms to hedge funds and algorithmic traders, looking to buy or sell when a natural counterparty to a trade doesn’t materialize. According to Thomson Reuters Autex, which tallies self-reported or “advertised” block trades, the top ETF trading firms include Bank of America Merrill Lynch, a unit of Charlotte, N.C.-based Bank of America Corp.; the market-making division of Jersey City, N.J.-based KCG Holdings Inc.; and Credit Suisse Group AG. 

Exchange-traded products exist in two markets, the second of which is simply the open market where individual investors buy and sell shares. The first, the primary market, is a wholesale market for mutual-fund shares, issued once a day at net asset value. Only certain trading firms, known as authorized participants, can participate in this market, where they swap securities and cash with an ETF to create (or redeem) shares.

According to research from the Investment Company Institute, ETFs on most days see little trading in the primary market, because it takes a big institutional order or price imbalance for new shares to be issued or shares to be redeemed. Using their assessment of the basket, the fund in general, and external factors affecting the prices for individual securities in the basket, market makers determine what bids and offers to post. Their goals are several: to post bids and offers that will best contributed to a fluid market, win them the order, and earn their keep through trading spreads and rebates from exchanges and securities marketplaces that compensate traders for keeping the market fluid.

Bigger challenge 

For products based on more-complicated indexes—including alternatively weighted “smart beta” funds—and actively managed ETFs, the market makers’ challenge is greater. Most ETF and stock trades settle over several days. More complex securities, such as bank loans and foreign stocks, can take more time, but the market maker is not actually looking to take on the risk of directional moves in the market. When ETFs were mostly based on brand-name indexes, market makers could hedge away that exposure using readily available index futures and other derivatives. But as ETFs have become more alpha-seeking and niche, hedging away the risk of carrying the exposure is more expensive and requires more complex models.

Enter the LMMs 

At NYSE Arca, where 88% of U.S. exchange-traded products are listed representing 94% market share by asset, there are nearly 350 firms with equity-trading privileges, including 42 market-making firms, 20 of which serve as lead market maker. These so-called LMMs at NYSE Arca have signed up for a greater obligation to provide quotes on specific products, in exchange for greater incentives from the exchange.

While Nasdaq and BATS, the other listing venues, don’t explicitly have LMMs, these exchanges have developed their own incentive systems to ensure that market makers are providing quotes. These incentives, like NYSE Arca’s, include scaled rebates based on how much liquidity market makers provide.

Click here to access the full article on The Wall Street Journal. 

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