Positioning the European ETF market for growth

The European exchange traded fund (ETF) landscape has changed dramatically in recent years with the entry of new promoters and the emergence of innovative products. But before it can grow even further, it needs to overcome a series of challenges, many of which are already being addressed by new initiatives, particularly in the over-the-counter (OTC) electronic execution space.

ETFs have seen consistent, fast-paced growth in assets since their launch more than two decades ago. In the US, ETFs and exchange-traded products (ETPs) are firmly established investment vehicles with combined assets of $1,701 (€1,238) billion, according to year-end figures released by ETFGI. Most trading in the US also takes place on-exchange by institutional and retail investors alike, allowing for ample visibility into the market’s depth and liquidity.

In Europe – where the first ETF was introduced in April 2000 – the majority of ETF investment comes from financial institutions, such as pension funds and traditional asset managers. While assets have steadily increased in recent years, a total market value of around $418 billion, according to ETFGI's year end data, suggests there is potential for further growth. Regulatory initiatives are expected to drive more business towards ETFs, particularly on the retail front. A good example is the UK’s Retail Distribution Review (RDR), in force as of January 2013.

However, Europe continues to face challenges, including market fragmentation, limited transparency and perceptions of illiquidity, which are affecting the pace and scale of its future growth.

A disjointed and blurry landscape

As at year end 2013, there were 1,995 ETFs/ETPs in Europe compared to 1,536 in the US, according to ETFGI. Yet the total number of European listings adds up to more than 6,200, since many products are denominated in more than one currency and traded across 25 exchanges. This has led to a high degree of fragmentation in on-exchange liquidity.

Consequently, market makers need to create 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 time to adjust all their quotes, dealers tend to limit the size in which they make public markets. As a result, institutional investors opt to perform the bulk of their ETF transactions OTC.

It is estimated that around two-thirds of trading volume in Europe is carried out OTC, typically by phone or chat. Both can make it difficult for investors to obtain much-needed visibility into the liquidity of the products they hope to trade, and to get a full picture of overall trading activity.

In addition, traditional OTC execution is inefficient and time-consuming, and involves the risk that the market moves between quotes from different dealers. Moreover, in an asset class where many different instruments have similar names, it is all too easy to trade the wrong listing with many ramifications, including issues with trade processing and settlement.

Upcoming regulation is also a factor. The broad nature of potential MiFID II requirements means they will likely encompass ETFs, putting the onus on institutional investors to prove “best execution”. Extracting and reporting relevant data from phone calls or chat logs will be laborious, and will make it difficult to prove that the best price was achieved.

The value of electronification in OTC trading

Venues that aggregate liquidity in one place while providing greater efficiency and a mechanism for recording trade data, like Tradeweb, satisfy many of these concerns and could absorb a significant portion of OTC trading activity.

On multi-dealer electronic marketplaces, institutional investors can request quotes for the entire size needed from several liquidity providers at the same time, achieving greater pre-trade price transparency.

In addition, electronic trading platforms have developed technology that improves trade execution workflow. For instance, Tradeweb functionality gives precise identification information to avoid confusion over which ETF is being traded, and can alert investors selecting anything other than the best price. At the same time, connections to risk and order management systems limit manual inputting errors and assist 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 produce customised reporting and analysis, as well as compliance audits that can assist in proving “best execution” are also typically available.

The path of future growth for European ETFs

The ETF market is broadly shaped by a search for liquidity and efficiency, and the need to satisfy all aspects of what will be a more stringently regulated environment. Electronic platforms allow larger trades to be carried out in an efficient and recorded manner: from price discovery, through execution, to processing and reporting. This will boost confidence in the depth of the market and improve perceptions of its liquidity.

Addressing the issues of market fragmentation, restricted transparency and illiquidity perception should help the ETF market to achieve its potential in Europe – raising volumes and daily flow.

 

 

Adriano Pace is head of the ETF marketplace at Tradeweb. Tradeweb builds and operates 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. https://www.tradeweb.com/Institutional/ETFs/