The worldwide exchange-traded fund market has gained significant momentum since the launch of the first ETF in the United States, in 1993. The first ETF in Europe, the iShares DJ Euro Stoxx 50 (EUN2), was launched only seven years later, in April 2000. Since then, the European exchange-traded product market has grown rapidly to include 1,1031 ETFs and exchange-traded commodities, with over 3,000 separate listings, at the end of 2009. European ETP assets under management rose to $223 billion2 by the same date (see Figure 1).
In terms of average daily trading volume, Europe lags behind the U.S. considerably. European average daily turnover was $2.3 billion in 2009, compared with $45.8 billion in the U.S. (see Figure 2).
One of the major differences between the European and the U.S. ETF markets is that, in the U.S., there are only one or two ETFs tracking each given index, whereas in Europe, one index is tracked by 78 separate ETF listings, and many others have multiple listings as well.
In this article, we will examine the reasons for this fragmentation, and the effect it has on the liquidity of ETFs in Europe.
Examples Of Fragmentation
The fragmentation in Europe is caused by two factors: 1) Competition between issuers; and 2) inefficiencies in the structure of the European financial markets. Combined, these have fractured the ETF market with significant impacts on end investors.
For example, consider the Dow Jones Euro Stoxx 50 Index (“SX5E”). Widely popular, SX5E is tracked by the most liquid European index futures contract (listed on Eurex), as well as some of the largest and most liquid ETFs in Europe.
But as of December 2009, there were 78 different listings for ETFs tracking the SX5E (see Figure 3). This excludes numerous structured delta-1 notes listed on platforms like Scoach.
Fragmentation Caused By Competition Between Issuers
Unlike the U.S., the European market is not one single market (although some politicians are working very hard to make it that way). Banks still have some weak form of monopoly in their home markets and are used to charging high fees to their clients. Given this background, the key issue for ETF asset growth in Europe is still distribution. ETFs compete against a variety of products, including mutual funds and structured products from those same banks, and therefore the accessibility of ETFs and their visibility to potential clients is very important.
Any ETF issuer will have to reach potential investors in order to gain AUM. Any U.S. ETF provider seeking brand awareness can advertise on a national level; for instance, during the Super Bowl or another high-profile event, or alternatively, advertise in a national business newspaper like the Wall Street Journal. By contrast, European ETF providers need to advertise in a variety of magazines, papers, TV channels, Web sites and so on, throughout multiple different European countries, to achieve the same results as their U.S. counterparts. Furthermore, there are simple information faults and language confusion, as well as a home-trading bias among investors in certain countries: Italian retail investors will have a very hard time finding prices for London-listed ETFs, and the typical German retail investor will probably never trade on a foreign exchange. Most issuers therefore choose to list their ETFs on several exchanges, increasing the visibility for investors but fracturing the overall liquidity. In addition, buying ETFs outside an investor’s home market can prove to be quite costly, as banks typically charge higher commissions for transactions outside domestic markets.
In response to banks fishing for each other’s customers (by listing on exchanges outside their home market), we increasingly see what we call the “defensive” or “me-too” ETF providers. Defensive ETF providers only start issuing ETFs when they lose too many fee-paying clients to international ETF providers. These defensive ETF providers typically originate from the asset management division of local banks and anxiously try to keep competition (like market makers or high-frequency traders) out of their products and keep the profits in-house. In our opinion, these ETF providers will not profit from economies of scale in the long run, and will either retreat from the ETF business, or merge with their larger international competitors.
In response to this, some banks have decided to share the costs and their distribution networks, and have teamed up in ETF consortia. There are currently two such consortia in Europe:
- Source (Morgan Stanley, Goldman Sachs, Merrill Lynch, Nomura)
- ETF Exchange (ETF Securities, RaboBank, CitiGroup, Merrill Lynch)
It is very difficult for ETF providers without a strong distribution network to autonomously grow assets under management. The one exception in Europe would be ETF Securities (ETFS), which was founded by ETC pioneer Graham Tuckwell, and which recently reached $16 billion in AUM. ETFS has reached this level by focusing only on ETCs and without any distribution power at the first launch. ETFS’ strategy was to list their ETCs on multiple exchanges in Europe, and then use an intensive one-on-one sales approach and marketing campaign to drive interest.
As ETF providers typically experience the distribution issues detailed above, assets and trading volume tend to be concentrated in the country of origin of the ETF provider. Figure 4 illustrates this.
This fragmentation of trading volume impacts the quality of the order book. Figure 5 contains an example of a reasonably liquid ETF, the db x-trackers DJ Euro Stoxx 50. As can be seen, the order book is filled with bids and offers, and the spread is about 7 basis points (2 euro cents vs. a midprice of 29.07, using the best available bid and offer).
ETFs with large trading volume attract market makers and high-frequency trading firms, creating a full order book. In contrast to the listing on Xetra, the absence of a customer base in the U.K. makes for an empty market and a wider spread of approximately 20 basis points in the LSE listing.
Issues Caused By Fragmentation
Again, unlike the U.S., the European clearing and settlement system is not a homogenous entity. Every exchange has its own central counterparty (CCP) and central securities depository (CSD), and therefore every listing settles in a different place. In order to balance positions between settlement venues, ETFs need to be transferred from one location to another, which costs money and can take several days. This is only the start of a whole range of issues arising from different settlement locations, including:
- Different settlement cycles (T+2, T+3)
- Prime brokers and clearinghouses might use an omnibus account at the CSD. Consequently, ETFs can effectively be loaned out by the clearinghouse to another trading firm, without prior knowledge and/or approval from the owner of the position. Once loaned, the ETFs cannot be transferred. (It is very difficult to transfer shares that are not actually in your account.)
- The LSE has a 30-day settlement period, which basically means that settlements can take up to 30 days. This leeway is frequently misused by hedge funds and trading firms. Again, it is very difficult to transfer an ETF that is not “settled long.”
- Monte Titoli (Borsa Italiana) does not net-off trades, so a short sale followed by a cover buy will not be netted off. You first need to buy somewhere else and then transfer to Italy for this trade to settle.
- Some CSDs do not connect to each other, so ETFs must be transferred using a third country, which takes extra time and costs extra money.
European exchanges have a policy of forcing a buy-in when ETF trades don’t settle, imposing penalties of up to 100 percent of the notional value of the trade. This practice further reduces liquidity, as market makers and other liquidity providers are limited in their short-selling capabilities. Liquidity providers are obligated to put quotes in for every listing, including the listings that do not trade (they also have to maintain inventory to prevent buy-ins). For some ETFs, this can lead to maintaining inventory and bid/offer prices for more than nine listings.
In the end, all individual quotes are typically smaller in size than they would have been if there were one single listing. In contrast to other issuers, Source has chosen to list its ETFs on only one exchange, thereby preventing these effects. Its goal is to concentrate all liquidity in its products in one single place. Moreover, unlike Reg NMS, the European MiFID regulation does not enforce true best execution. Brokers can choose to route all flow to one exchange, completely ignoring better prices on other exchanges.
Impact On Liquidity
In the end, all client orders are spread over many different listings, therefore effectively reducing the liquidity of the investment product. End-investors almost always have to cross the bid/offer spread, and working an order against other investor flow is very difficult. Another consequence is that a significant proportion of the trading volume in ETFs in Europe is traded over the counter (OTC); some even estimate that OTC trading represents more than 50 percent of the total trading volume. A precise number is hard to determine, as no obligation exists under the MiFID regulation to report OTC trades. Brokers who trade off-screen use the appearance of low screen-based liquidity to promote themselves as alternative liquidity pools. Although an order might easily have been executed on-screen, a larger order is usually done OTC. This is the case for most orders above €10 million, and sometimes even much smaller orders are traded OTC.
What can be done to make European ETFs more liquid? The distribution problem is something politicians have been working on for 50 years by trying to form the European Union. Unfortunately, as long as Europe remains divided, issuers will have to spend more time, effort and money on marketing in each individual country. A good start would be to ease regulations that require ETFs to be listed locally to be allowed to be sold. The issue of Europe’s fragmented clearing and settlement system could be solved by having one central or several linked CSDs, much like the Depository Trust & Clearing Corporation in the U.S., in combination with stricter regulations on best execution. Finally, an obligation to report OTC trades would increase transparency.
1 Source: DB Index Research, Weekly ETF reports—Europe, January 21, 2010
2 Source: BlackRock ETF Landscape Year End 2009
BlackRock Advisors, ETF Landscape, Industry Preview, Year End 2009
DB Index Research, Weekly ETF reports—Europe, January 21, 2010