Clash Of The Protocols

December 24, 2013

In Europe, “exchange-traded fund” is a misnomer. By most estimates, 60-70 percent of the region’s trading in ETFs doesn’t take place on stock exchanges at all. Instead, investors negotiate deals with their banks and brokers in the bilateral, “over-the-counter” (OTC) market.

ETF market participants shun stock exchanges for a reason: the liquidity on exchanges’ order books is insufficient. In all but the most actively traded funds, the market makers responsible for posting orders to buy and sell ETFs—each fund has to have at least one contracted (or “designated”) market maker, and most have several—do so at spreads that are too wide, or in volumes that are insufficient to cater for investors wishing to transact in size.

The shallowness of ETF order book liquidity reflects Europe’s complex market structure.

A single fund may be listed on several exchanges across the region and in different trading currencies. Each exchange sets its own trading rules and offers different incentives to those quoting prices. After ETF trades are concluded, orders are dispatched into a network of competing clearing and settlement systems. As a result, market makers find it costly and slow to net off a long position on one market with a short position in another, even if the underlying instrument is the same.

The resultant risk of mispricing means that in many Europe-listed ETFs, market makers are reluctant to show willingness to buy and sell large volumes of fund units. Where they do quote, it’s often with wide bid-offer spreads.

Europe’s market participants frequently refer to ETFs’ “liquidity gap” or “hidden liquidity” to reflect the fact that the orders displayed on stock exchanges often understate the true demand to buy and sell ETF shares.

To unearth this concealed liquidity, institutions often trade on a bilateral basis—traditionally, by picking up the phone to a bank’s trading desk and asking for a “risk” price.

Now, the off-exchange market for ETF trading is becoming institutionalised via so-called “request for quote” (RFQ) platforms, offered by an increasing number of vendors: Tradeweb, Bloomberg, RFQ-hub and, most recently, Bondvision RFQ, operated by the London Stock Exchange.

Institutional investors who have signed up to an RFQ platform can poll a number of approved counterparties when they wish to trade in an ETF. When dealers respond, the investor can select the best price and trade electronically.

OTC trading, including that done by RFQs, lacks a number of the benefits of trading on-exchange.

Exchanges’ “central limit order book” model means that trading is anonymised and there’s transparency of pricing all the way through from pre- to post-trade. Deals conducted on-exchange are cleared by a central counterparty, eliminating buyers’ and sellers’ mutual credit exposures.

But in the OTC market the identities of counterparties are disclosed pre-trade, and deals are between banks/brokers and their clients only. There’s limited or no transparency on pricing, it’s hard to know if you’ve got the best available deal and there’s a constant risk of tipping the market off about your trading intentions, potentially moving prices against you. And trading bilaterally means you have to have an approved credit line with a counterparty before you even start.

The London Stock Exchange told that its new RFQ platform caters to a different segment of the market than those trading on-exchange.

“We feel that our RFQ trading platform is complementary to the trading of ETFs on the London Stock Exchange’s and Borsa Italiana’s official order books,” Fabrizio Testa, head of product development at MTS Markets, a London Stock Exchange subsidiary, told

“We’re targeting the activity that is currently happening over-the-counter. A fund manager with a large order to execute at once will probably not try to do it via the order book. RFQ systems also allow you to trade with a flexible settlement date, whereas trading on exchange is with a fixed settlement cycle,” said Testa.



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