Regulation Holds Back ETF Liquidity

Laws require creation baskets for funds to be at least $1 million in size, which hurts smaller, less liquid ETFs.

ETF issuers often find themselves dealing with all aspects of ETF liquidity—from education around liquidity to the facilitation of it.

The focus on liquidity is precisely the reason many issuers have dedicated entire departments—referred to as capital markets desks—to deal with these issues. Capital markets desk professionals find themselves doing everything from trade guidance to acting as a liaison between ETF liquidity providers and portfolio managers, all in the name of facilitating liquidity and ensuring things go smoothly for all parties involved in ETF trading.

There are many ways for an ETF issuer to enhance ETF liquidity after an ETF has come to market. However, much can be done to enable liquidity before an ETF even comes to market. One of these methods has to do with constructing the creation-unit basket of an ETF.

To understand the importance of proper creation-unit basket construction, it’s key to understand ETF trading from the perspective of a market maker or liquidity provider. However, let’s first examine the role of an issuer.

Imagine you’ve come to market with your very own ETF—we’ll call it the “The Awesome Smartest Beta ETF,” ticker symbol: AWE. Your intent is to target AWE at institutional investors. As a result, you as an issuer are highly conscious of brokerage costs—so you design the share price of the ETF to start at $100—the idea being that institutional investors, whose trading costs are often on a per share basis, can acquire more (notional) exposure with less shares.

Along with that, you also need to think about the creation-unit size you’re constructing for AWE. You decide it’s best to go with the standard 50,000 shares. In short, authorized participants (APs) who want to create new shares, or redeem existing ones, can only deal with you in 50,000-share lots.

The problem with the above example is that the process is more of an art than a science. Although the above example may seem great as a product for institutional investors, it actually makes for terrible liquidity construction.

As an AP/market maker in AWE, one creation unit of the ETF amounts to $5 million of the market maker's capital (50,000 shares x $100/share). Also consider that you need to maintain a hedge. Assuming this was a rudimentary hedge shorting the underlying basket of securities, the market maker would incur additional borrowing costs to short the underlying basket of securities in AWE.

It’s likely a market maker wouldn’t have to put up all the capital necessary for a short position. However, you still have a scenario where the market maker is using up north of $5 million in capital to hold one creation unit of AWE.

Hence, in a scenario where AWE is a new fund that lacks significant volume, the market maker likely is left sitting with that exposure over time, incurring costs—not to mention the opportunity cost of deploying capital to other opportunities.

As a result, if you’re a new ETF issuer or an ETF issuer bringing an innovative product to market, there are two things to consider when constructing the basket. First, you need to construct a basket that’s most suitable for your portfolio manager and the strategy/exposure they’re aiming to provide in the fund. Secondly, creation baskets need to be constructed in a way that minimizes a market maker’s risk.

So why does this matter? At the end of the day, there’s a positive correlation between the risk that market makers have to take to provide liquidity and the trading costs for buy-side investors. The bid/ask spreads and premiums/discounts that buy-side investors experience in the market are directly informed by the risk that market makers have to take.

Ideally, nothing would make a market maker happier than smaller creation-unit sizes. Oftentimes, a multimillion-dollar creation-unit notional size does the trick for larger ETF issuers whose sales force can push product. However, smaller players can benefit hugely from smaller creation baskets (assuming the smaller creation amounts still meet the needs of the fund’s portfolio manager).

Unfortunately, outdated and unnecessary regulation is actually hindering the use of smaller notional creation-unit sizes for ETF issuers that need to facilitate liquidity. According to the SEC’s 2006 response to an inquiry, ETF creation-unit sizes must be at least $1 million.

Although $1 million might seem small to some, from a market maker’s perspective, it could be burdensome for less liquid ETFs. The ability to create and redeem shares in notional amounts less than $1 million gives market makers the ability to free up capital more quickly while likely reducing trading costs in less liquid ETFs for investors.

Of course, this is one of the many things that can be done to enhance the liquidity of less traded securities, but it’s a good starting point nonetheless.

Contact Ugo Egbunike at [email protected].