Means-testing is a must for market makers, Knight's Browne says.
With 17 years of experience trading exchange-traded funds, Reggie Browne is one of the most authoritative voices in the world of ETF market-making. Browne’s firm, Knight Equity Markets, executes 136 million shares worth of trades each day, making it one of the largest ETF traders in the country.
IndexUniverse.com Managing Editor Olly Ludwig and IndexUniverse.com Correspondent Alex Ulam caught up recently with Browne—the managing director of Knight’s ETF team—for a telephone visit to discuss the opportunities and challenges facing ETF market makers in a world of high-volume electronic trading.
Ulam: What gives you your competitive edge?
Browne: One of the competitive advantages is the fact that we deal with 720 broker-dealers. We have the majority of the flow.
Ulam: Do you have some technological edge too?
Browne: We’re really a tech firm, so everything here is homegrown and built internally; nothing is off the shelf, so our costs are low in comparison to our competition. Also, when we bought the Kellogg Capital Group two years ago, that deal launched Knight on the New York Stock Exchange and made us a lead market maker for ETFs. And we took that unit from 30 people down to five. That gives you an idea of the cost efficiencies associated with technology.
Ludwig: A lot of people talk about market-structure problems. How do you see the big picture now that the market makers who used to rule the roost on the floor at the Big Board are pretty much artifacts?
Browne: These days, there has to be a test of who’s a market maker, and there needs to be a better relationship between providers of liquidity and the high-frequency guys who are just quoting to get rebates from exchanges. And there should also be some means-testing.
So for example, there should be a best-price obligation. A true market maker should publish two-sided quotes with various depth levels. So, not just top-of-the-book, but also quotes down three or four levels to provide ample liquidity to prevent a “flash crash.” The flash crash really happened because people turned off their machines and walked away. No one was accountable to maintain a fair and orderly marketplace.
Ludwig: You’re talking about going beyond Reg NMS (regulation national market system).
Browne: That’s correct. There should be a best-price obligation, there should be a mass-quoted spread obligation and there should be some sort of price bands around last sales. Also, there should be a minimum stock requirement. And finally, there should be a higher capital requirement.
Ulam: What are some of the key challenges regarding new ETFs coming on the market in terms of establishing liquidity?
Browne: If you look at the ecosystem of ETFs, market makers historically rest at the arbitrage band. Wherever the arbitrage is located, market makers will begin quoting at that band. And the further you go through this band, the more liquidity shows up. That’s fundamental. There’s no disagreement about that.
But what’s missing with new ETFs is that you have the market makers quoting inside the arbitrage band; what’s missing is the retail flow inside the arbitrage band, keeping the appearance that ETFs are liquid and tight.