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.


MJ Lytle, chief development officer at ETF issuer Source, pointed to the operational advantages of RFQ platforms.

“RFQ platforms mean moving from decentralised OTC business to some centralisation,” Lytle told

“One of the problems of OTC trading is logistical: you have to call three or four people for prices and by the time you’ve asked them all the price may have changed. RFQ controls for this because as a broker on the platform you can decide how long you want to display a quote for. Every time you refresh your quote the system works out who’s most competitive,” Lytle said.

Leland Clemons, European head of capital markets for iShares, attributed the popularity of RFQ platforms to the ETF market’s fragmentation.

“The absence of a unified European market structure makes a variety of execution choices important for clients,” said Clemons.

“Until an Italian private banker can take advantage of an ETF price on, say, Euronext Amsterdam, brokers and trading desks are going to have to find liquidity rather than having it presented to them.”

But while the benefits of RFQ platforms for institutional investors seem clear, some market participants suggest that making off-exchange trading more efficient could undermine the basic premise of ETFs.

“These new RFQ platforms institutionalise OTC trading,” Frank Mohr, head of ETF sales and trading at Commerzbank, told

“For clients, it’s a perfect world. They have a nice new tool and they can easily put five market makers in competition to find the best price in a particular product. But this is pulling business away from the exchanges, thinning out the order book and reducing visibility. If you’re trying to get new people into ETFs, that’s a problem,” said Mohr.

Keshava Shastry, head of capital markets for Deutsche Asset and Wealth Management, struck a similar note of caution.

“It make sense to trade an ETF on an RFQ platform if the fund tracks markets that are not very liquid, where there’s not much depth on the exchange order book or when a client needs to trade in larger size than is currently available on-exchange,” said Shastry.

“But if RFQ platforms are being used for small-sized trades in liquid ETFs this is effectively driving liquidity away from the central order book and making trading even more fragmented, as well as reducing transparency,” he said.

“I’m surprised to see some of the exchanges launching RFQ platforms, as this means they are basically promoting OTC trading. The beauty of ETFs is that they are exchange-traded, on a regulated market, and with central clearing,” Shastry said.

One way of keeping a significant proportion of trading on-exchange could be for exchange-owned RFQ platforms to limit their business to orders of above a certain cash amount, said Shastry.

According to one ETF market maker, who requested anonymity, some European exchanges are preparing to offer an “on-exchange” version of RFQ trading, under which institutional investors could poll traders as before, but where the traders’ quotes would be displayed on the exchange’s order book, and where any resulting deals would not only be reported but also centrally cleared.

As things stand, RFQ platforms disclose little about their business. Tradeweb told that its average trade size was €2.5 million but declined to answer questions about the volume of trades conducted on its platform or its method of charging platform users.

For Europe’s largest issuer of ETFs, disclosing details of platform trades to the broader market is an important next step for the RFQ operators.

Currently, trade reporting for a large proportion of Europe’s OTC market is voluntary, meaning that no one knows the size of aggregate turnover in ETFs, or details of the pricing and size of off-exchange trades.

“While choice and innovation are good, transparency is paramount,” said iShares’ Leland Clemons.

“We’re aligned with a variety of constituents, including regulators and policymakers, in wanting greater transparency. 60-70 percent of European ETF trading is OTC and activity needs to be reported in order for transparency to improve.”

For the time being, the two trading protocols for Europe’s ETF market—order book and RFQ—operate side by side, and in an uneasy truce.



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