In recent years, exchange-traded funds (ETFs) have seen phenomenal activity and growth. Regulation, product innovation and investor appetite have driven global Assets under management (AUM) to record levels, while also fueling increasing market structure complexity and straining trading platform capabilities across the board. Itiviti, in conjunction with GreySpark Partners, recently engaged in a comprehensive review of the ETF trading landscape, covering market structure, trends and predictions, and the consequent implications on market participants and the trading technology stack. This article summarizes several aspects of GreySpark’s analysis and the resulting whitepaper now available from Itiviti.
Market size and structure
AUM in ETF products was estimated at USD 3.7 trillion globally at the beginning of 2017, up from USD 300 billion in 2007. While the growth of >1200% over the past decade is impressive, ETFs still only account for a fraction of the total held in investment funds globally, estimated at 3% of total fund AUM. Regional differences in participation, regulation and how products are physically traded make for a varying market structure across jurisdictions – a crucial factor in ETF business model and trading technology development.
The US is the largest marketplace for ETFs, growing >500% from 2006 to USD 2.29 trillion in AUM at the end of 2016. ETF liquidity is largely held on-exchange, with an approximate 70/30 split between exchange-traded and OTC-traded activity. The largest and most significant exchange is the NYSE Arca platform, where 1,270 ETFs are traded by 14 bank and non-bank market-makers.
The scale of retail investment in the US ETF marketplace is the key differentiator from other regions, where 40% of US households own ETFs compared with only 11% of European households. However, the prevalence of retail investment and the exchange-centric structure has led to some inefficiencies, with ETFs seeing less than USD 5 million in average daily shares traded (ADST) being effectively illiquid. This has led to increased demand from asset managers and institutional investors for anonymous block-size trading capacity, accelerating potential growth in quote-driven trading models and platforms such as Tradeweb.
Europe is the second-largest ETF marketplace globally, with USD 509 billion in AUM at the end of 2016. In Europe, ETFs are now more often RFQ-traded than on-exchange, with approximately the reverse distribution of that seen in the US – 50%-70% of all activity is traded on OTC RFQ platforms. Euronext is the largest regulated market, with 1,450 ETFs listed across all platforms, traded by 22 bank and non-bank market-makers.
In 2017, the European ETFs marketplace is characterized by liquidity fragmentation and price opacity. ETFs are typically listed on multiple exchanges, often in more than one currency, furthering the dominance of request-driven trading models. This fragmentation is magnified by the fact that there is no centralized settlement repository in Europe, meaning the additional cost and time required to move inventory between depositories is reflected in on-exchange spreads.
Inter-APAC, the ETF marketplace is the smallest of the three regions with USD 323 billion in AUM at the end of 2016. ETFs are predominantly exchange-traded, with little or no RFQ trading between fund managers and banks or brokers. At the end of 2015 there were approximately 915 ETFs listed across 14 exchanges, with key hubs in Australia, Hong Kong, Japan, and mainland China.
The APAC marketplace is largely comprised of equities ETF instruments, with fixed-income ETFs experiencing increasing growth in recent years, reflecting a more global trend. With limited retail investor activity, and the continued institutional asset shift from mutual funds to exchange-traded instruments, quote-driven trading models could play a key role in shaping regional market structure.
Trends and regulation
Between 2003 and 2010, the ETF marketplace was dominated by equities-linked, physically-replicated products, with less demand for synthetically-replicated products. The marketplace was largely single-tier in nature, with most on-exchange market-making conducted by the same asset managers – or ETF sponsors – who were managing the creation and redemption process for their own products.
Since 2010, as investor demand grew for a wider range of ETF types, the structure of the overall ETF marketplace has shifted toward a two-tier model – on-exchange trading and dealer-to-client trading via OTC RFQ platforms. European and US banks have capitalized on this shift by offering new distribution and market-making services to their clients, allowing asset managers to focus primarily on ETF manufacturing instead, leading to product innovation and asset class expansion beyond more traditional, equities-centric products.
Regulation has also played a key part in marketplace evolution. In the US, the Securities & Exchange Commission regulates ETFs in the same way that it regulates mutual funds – as with end-of-day mutual fund Net Asset Value (NAV) trades, all US ETF trades must be reported to a public repository, which is normally the exchange venue.
In APAC, Hong Kong’s Securities and Futures Commission (SFC) has resisted certain product innovations, citing counterparty and liquidity risk in the case of synthetically-replicated products. In Singapore, the Monetary Authority of Singapore (MAS) began permitting financial advisers to trade ETFs for their clients on a case-by-case basis, while South Korea’s Financial Services Committee has been actively encouraging ETF participation, by allowing the country’s National Pension Service to invest in such products.
The most complex and impactful regulatory narrative is currently playing out in EMEA, in the build-up to MiFID II implementation in 2018. The trade reporting and best execution requirements introduced by MiFID II are broadly expected to be net positive for the ETF marketplace, as participants benefit from greater liquidity transparency, and consequently, the projected changes in ETF collateral and lending practices.
Impact on trading technology
These structural developments have implications for the trading technology stack of proprietary trading and market-making businesses. At Itiviti, we have been working closely with our clients and prospects to distill the core technology challenges, while also surveying the wider market for a more comprehensive view. Through this effort, we have identified five key functional areas for ETF trading that must be carefully considered to remain competitive in 2017, and beyond:
- Static data management: With the proliferation of new issuers and new products, comprehensive static data management and associated workflows is paramount – a mistake in fund composition will undermine all other trading platform functionality.
- Proxy pricing: For ETFs tracking world indices, or ETFs tracking illiquid underlyings, there may not be a reference price for all constituents, all of the time – a synthetic price must then be generated.
- Theoretical pricing: Efficient NAV calculation is vital for ETFs with many underlyings, and pricing models need inherent flexibility to keep pace with product innovation.
- Market making & hedging: With multi-listed instruments bringing liquidity fragmentation, and the rise of new trading models and venues requiring new core infrastructure and connectivity, scalability and control of market making operations becomes more difficult to maintain.
- Inventory management and risk: With more products and new product types, together with the increasing regulatory burden, additional demands are placed on risk and position management functionality.
The ETF marketplace has evolved significantly since its inception in the 1990s, and there are a raft of drivers and considerations which are continuing to shape the industry today. Interest and activity in ETFs has accelerated over the last few years, fueled by participant appetite, product evolution and regulatory initiatives. This trend looks set to continue with the rollout of new trading models, venues, and regulation in 2017 and beyond.
From a technology perspective, creating successful market-making and trading models involves several ETF-specific challenges. More generally, the qualities of performance, flexibility, regulatory compliance and multi-asset capability are quickly becoming market expectation, with the idea of ‘future-proof’ technology being a frequent theme during our initial research.