Learning About The Benefits Of OTC Trading

[This article comes from the Learn section of our website]

In most of Europe, the acronym “ETF”—exchange-traded fund—is somewhat misleading. While ETFs are definitely “traded,” the majority of all ETF volume is actually transacted “off-exchange.”

What does that mean?

Investors are used to trading stocks “on exchange.” That means you enter a market, limit or other order with your broker, and your shares are traded at a major exchange such as the London Stock Exchange.

In off-exchange transactions, investors trade in dark pools, electronic communication networks or directly with liquidity providers. These transactions are private and not governed by the same rules that dictate trading on a public exchange.

Investors utilize off-exchange trading for a variety of reasons. For one, investors can often achieve better-quality executions by working directly with liquidity providers and market makers. This is particularly true for large block trades. Moreover, off-exchange trading is not reported to a central tape, a level of anonymity that some investors like.

It may not always be necessary, but having alternative sources of liquidity is always something that can benefit investors.

Step 1: Custodial Agreements and Prime Brokerage

The first step to trading off-exchange with a liquidity provider is contacting the party responsible for the custody of your ETP shares and assets. Typically this is the party through which you usually trade ETF shares on an exchange. They’re also the party responsible for the settlement of your securities. You’ll need to be granted permission from them to “trade away” from their platform with a liquidity provider or market maker.

Keep in mind that custodians and prime brokers may charge a fee for trading away. It’s essential to determine the nature of this fee (variable or fixed) before deciding if the potential for trade execution quality outweighs the all-in costs of trading away.

Step 2: Understanding the Product and Capital Markets Help

Understanding the ETF you’re trading and the liquidity of the securities in the index it tracks is critical to a successful trade. When you contact a liquidity provider with whom to transact off-exchange, they’re quoting you a market of what they believe to be a fair price for shares of the ETF. Thus, it’s important to understand the fair value of an ETF, as well as the liquidity available in its underlying portfolio. Sometimes that information is difficult to access without expensive data feeds. There is, however, a solution: the ETF issuer’s capital markets desk.

The capital markets desk at an ETF issuer is one of the best resources available to investors. Most issuers staff a desk whose sole purpose is to help investors enter and exit funds at fair prices. Among their many services, capital markets desks can run underlying portfolio analytics and give a clearer picture of the market impact of buying the underlying securities. They can also help in referring you to liquidity providers from their own network. Best of all, it’s free.

Step 3: Selecting and Working with a Liquidity Provider

Selecting a liquidity provider is more art than science—it takes time, and some experience. It helps to stay with the trusted names, but also keep on the lookout for new parties that might be aggressive in their quoting in order to attract new business.

Remember, liquidity providers make their money off the flow (the number of shares you trade). On some days, they might quote aggressively because they can take on the risk in order to keep you as a client, and on others, they might quote less aggressively because they’re unwilling to take on the risk. Keep note of the types of ETFs you trade and with which liquidity provider. It’s likely you may notice some patterns as to who offers the best prices for any given market.

Step 4: Post-Trade Analysis

An independent post-trade analysis can be a good way to assess the efficiency of a trade ex-post. A post-trade analysis offers insight into the price at which your trade was executed relative to other transactions that occurred in the fund at the same time. Sometimes liquidity providers offer third-party tools to conduct post-trade analytics. Still, the more independent the assessment, the better.