The UK’s Retail Distribution Review came into force last year, banning kickbacks and boosting the case for exchange traded funds, but this year it is MiFID (Markets in Financial Instruments Directive) II that is keeping regulators awake at night.
The consultation period for MiFID II closed in August, and the impending new rules are anticipated to be a boost for the European ETF market because of the post-trade reporting requirements.
To give you an idea of the size of the European ETF market, it currently has assets of roughly $470 billion invested across 2,059 ETFs and ETPs over 25 exchanges, according to data from ETFGI’s end H1 2014 Global ETF and ETP industry insights report.
Trying to gauge trading volumes is a trickier proposition. This is because not all ETFs are actually traded on-exchange, despite being called exchange traded funds. Instead, some are traded over-the-counter (OTC), meaning they are traded in a bilateral agreement between two parties. ETFs may be exchange traded but they are not subject to the same pre- and post-trade rules as other exchange traded instruments, such as equities.
This means that while there may a huge amount of trading and sufficient liquidity in the ETF market, it is difficult to see what it is. Until MiFID II is implemented, there is still no legislation in Europe to require that trades be reported.
When you consider the ETF market’s main selling points are its liquidity and transparency, this seems to be at odds with the reality of trading them. It is estimated that over half of the European ETF market is traded OTC, meaning we only see on-exchange about 30-40 percent of total trading volumes.
But MiFID II will change all that when it comes into force on 3 January, 2017. What exactly are these changes and how will they affect the ETF market?
The rules impacting ETFs include mandatory trade reporting for OTC trades and a consolidated tape, which is an electronic program providing real-time data on volume and prices for exchange traded securities.
Norton Rose Fulbright comments in a briefing note from March this year that transparency requirements under MiFID II (and MiFIR) generally fall into two categories. “Firstly, there are general transparency requirements which can be separated into pre-trade and post-trade disclosure of the details of orders submitted to and transactions conducted on a trading venue (i.e. a regulated market (RM), multilateral trading facility (MTF) or organised trading facility (OTF)). Secondly, transaction reporting which involves notifying the competent authority of identifying reference and post-trade data.”
And it is the consolidated tape, which records all trading activity and Europe lacks, that will likely have the biggest impact for ETFs.
There are 28 different countries and 25 exchanges across Europe, resulting in a great deal of fragmentation. ETFs are cross-listed over multiple exchanges, raising the risk that shares on one exchange may be cheaper or more expensive than another, and it is tough for the end-investor to work out the total trading volume as they have to add it all up across exchanges.
A consolidated tape is expected to reassure retail investors as they will be able to see what is on- exchange. It will give investors the benefit of seeing aggregate average daily volume for ETFs cross-listed on multiple exchanges and make it easier to find the best price, as well as offer the greatest liquidity in secondary markets.
Michael John Lytle, chief development officer at Source, said: “It is particularly beneficial to have a consolidated tape for ETFs as they are supranational. Unlike single stocks which are identified with the country in which the company is incorporated, ETFs have no home jurisdiction. Centralising and exposing all trading activity in one location will be very useful.”