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.
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.
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
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