The make or break of European ETFs

Due to the strong growth of Exchange Traded Funds (ETFs) in Europe, market makers and traders are set to adopt enhanced tools to trade these instruments and offer ever more compelling reasons to take up a widening range of products on offer. Inves-tors now appear spoilt for choice with ETFs, products which allow exposure to a whole index or sector - in just one trade.

Originating in the US with offerings on the S&P 500 (SPDRs) and the Dow Jones Industrial Average, ETFs in Europe have largely been playing catch-up to the US market where these instruments account for some 25% of overall trading. Still, asset growth in Europe has zoomed to $140bn in 2008 from just $680mn back in 2000. And, last year the region saw ETF product inflows of $74bn versus $570bn mutual fund outflows. Looking further into the trading activity of ETFs, we can see they equate for 32% of

all US equity trading volume and it has reached 9.1% of the total European Equity market as of the end of April, an im-pressive rise from a relatively modest 2.8% a year earlier. It’s also interesting to see how the ETF volumes have risen

despite a general slowdown in trading activity.

Growth in Europe has also been buoyed by the fact that ETFs do not fall within the MiFID definition of ‘shares’. Rarely a day now seems to pass without the latest flavor of ETF launching. They are available on equity indices,

sectors and fixed-income and commodities like gold, physically replicated to an underlying basket of constitu-ents or via derivatives using swaps-backed ETFs.

Today, while the 701 ETFs offered in Europe compare favorably with the US number of 697 (June 2009), it is esti-mated that the instruments in Europe still only represent about 1.5% (vs. 4.6% for US) across all investment assets,

Orc Software examines the European ETF market; looks at current market requirements and key differentiators. Marketing Director Christine Blinke gets the latest trends and future predictions of the European ETF market from Lee Griggs, Managing Director and VP Sales Orc UK, and Senior Product Manager Markus Kämpe.

It’s also interesting to see how the ETF volumes have risen despite a general slow-down in trading activity.”“

Markus Kämpe (left) & Lee Griggs (right), Orc Software

including actively managed assets. The difference equates to $300bn worth of ETFs.

With volumes growing and the ETF product range continually expanding, market participants need to react with speed and intelligence in how they price, quote and control their positions and risk exposures. As fund provid-ers have many new ETFs up their sleeve for release in the near future these challenges will not go away. For example, iShares, part of Barclays Global Investors, which accounts for the biggest market share of ETFs in Europe at 38.7% (Q1 2009), claimed this June that it was thinking about “at least” 70 to 80 new categories.

Emerging trends in European ETF trading

As an ISV providing trading solutions for more than 20 years Orc Software has seen a fair share of its customer base ac-tive in the ETF market, and, as part of the core segments for Orc Software, the company has followed the market de-velopment closely. Lee Griggs, Managing Director Orc UK, gives the European perspective: “In EMEA we are prob-ably at a make or break point, there is increased focus on trading ETFs and more and more firms are investing in technology to better price and execute these products. Currently there remains a reluctance to push large volumes through if liquidi-ty isn’t obviously available, net result is that the flow will go to the primary mar-ket (the components of the fund/basket).” Griggs con-tinues: “Having said that, we start seeing cracks in that reluctance with more aggressive market partici-pants increasing their ETF trading activity. Our gut feeling based on the indi-cations we see in today’s market is that it will turn into a more general trend where more aggressive participants increase their pres-ence in European ETF trading with improved liquidity and a more competitive market as a result.”

Looking at the development at specific exchanges, the London Stock Exchange (LSE) currently has ten ETF market markers. LSE has around 200 listed ETFs from providers like BGI’s iShares. The value of ETFs traded on the LSE rose to £34.7bn (€39.5bn) in 2008 and came in at £12.2bn in for the first quarter of 2009 (2000: £1.3bn). This year could see a 40% growth in the LSE’s ETF trading

volumes, if Q1’s 2009 number is matched over the next three quarters. Last year’s numbers only make up 3% of total value traded across the exchange group - including Borsa Italiana (BIt), which posted ETF turnover of €46.6bn in 2008 (€10.7bn: Q1 2009).

BIt’s ETF-Plus market, which currently has eight market makers, offers 300 ETFs that are listed through Milan. Hopes are high that further integration of ETF-Plus on the LSE group’s trading platform later this year should provide an extra boost.

ETF market making challenges

The increased number of liquidity pools following MiFID together with improved liquidity in ETF trading mean more opportunities for the market participants, but also tougher challenges as the markets get more competitive. They need to stay efficient and competitive, which means continuously seeking to improve their trading activity.

A significant challenge in an ETF market making opera-tion is to keep costs low and at the same time not restrain the trading activity. Historically (and still) there are many ETF market makers doing a lot of non-productive admin-istrative work to keep ETF definitions up to date and gen-

erate accurate quotes to send to the market. Most of the times the exist-ing market making set ups are based on Excel spread sheets or legacy software, implying high cost of ownership and slim chances of working efficiently and keeping up with competition.

Griggs acknowledges the efficiency aspect: “As head of an ETF market making operation you cannot afford traders fo-cusing on anything else but the profit generating

market making activity. You need to be able to take on new products or challenges without worrying about additional costs often connected to using legacy trading solutions built for the market making needs seen some years back. When talking to these decision makers it is clear that this is a major concern for them and they feel they need to move away from those solutions to be able to get to the profit levels they are looking for.”

Hedging is at the very heart of any successful market making strategy and ETF market making is no exception

to that. “There’s a push for flexibility,” contends Griggs when talking about the timing of hedge executions.“ Be-ing able to define when to make a hedging decision within a trading system adds value. So, how long do I hold the position before looking to hedge or do I hedge it only if the market moves in a certain direction? Market makers build this knowledge over the years and if they can put this trading intelligence into the trading logic in partial or full automation, they increase their chances of staying on top

of the market and keeping their competitive edge.”Timing of hedge executions is only one part of the

hedging strategy for a sophisticated ETF market maker. In many cases there is also a choice of instrument to use when hedging, where for example a CAC-40 ETF could be hedged by using the individual stocks making up that basket on, for example, NYSE Euronext Paris or an alternative MTF venue such as Chi-X or Turquoise or even the traded CAC-40 index futures. Depending on current market prices and volumes the preferred instruments to use for hedging might (and likely will) vary during the day and market makers being able to make this decisions at the time the hedge order is to be sent are likely to have a significant advantage in a more competitive market.

Griggs finishes the discussion on the subject by saying: “There is a lot to discuss and understand about hedging in ETF market making, but putting it short; in a competitive market you as a market maker need to have flexible low-latency execution on the liquidity pools you want to stay in front.”

Quote generation is another aspect of ETF market making where market participants really have a chance of increasing their likelihood of being successful. Having the ability to flexibly adjust the prices being generated adds further value to the market makers of ETFs. Griggs comments “The ability to lean the quotes based on exist-ing positions or view of the market is vital when pricing ETFs. This can be done in very simple terms, by purely adjusting the calculated result in percentage points, or by an absolute offset. However, it’s also possible to adjust the individual components of the basket composition and as such calculate the ETF from these input valuation

prices, this allows single modifications to have an effect on multiple products where the individual equity is part of numerous fund definitions”

Legacy IT or Excel spreadsheets to price and quote ETFs and some sort of FIX layer for market access clearly is never going to be as fast as receiving market infor-mation directly, making calculations and disseminating quotes directly to the market in a server based trading solution. The increased presence of low-latency algorith-

mic trading engines in the market also makes it important for market makers to reduce la-tency in their quote updates and at the same time build intelligent safety mechanisms into the market making logic for the market maker to not get picked off in case the quotes are, for some reason, off.

Griggs: “I really see this challenge as com-pletely integrated with the other challenges discussed. Even though the ETF market mak-ers currently might be using different tools

for administration, hedging and quote generation there is really no reason for why it should be like that, rather they go hand in hand. I see requirements like; automation, scalability, flexibility and low-latency; and my view on this is that there are trading solutions capable of handling this today; where ETF market makers can price, quote and hedge a large number of ETFs in a flexible and efficient way without relying on multiple or legacy software solu-tions.”

Arbitrageurs to follow where liquidity goes

With an increa-sed liquidity, the ETF market is likely to seriou- sly attract pla- yers from the more advanced market taking segments.Markus Käm-pe, Senior Pro-duct Manager at Orc Software says: “Based on the interest from the Eu-ropean market participants it is likely that the European ETF market will build even better liquidity going forward. In the US, where the ETF market already has good liquidity, we know that there is significant arbitrage trading activities and a not too daring prediction is that an increase in ETF liquidity in Europe should allow arbitrage trading firms to be more active in the ETF market than they are today. This

There is a lot to discuss and understand about hedging in ETF market making, but putting it short; in a competitive market you as a market maker need to have flexible low-latency execution on the liquidity pools you want to stay in front.

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means we predict a surge for low-latency arbitrage solu-tions in the coming years in the ETF space in Europe as a result of today’s increased ETF market making activities.

On a more general note Kämpe continues: “The market making and arbitrage trading segments have both seen a significant focus on efficiency improvements and the ETF business is no exception to that. Trading solutions requir-ing a high level of manual interaction are replaced by so-lutions based on flexibility in integration, automation and trading logic. Together with the increasing need of low-latency trading to stay competitive in the market we see a trend among ETF market participants to opt for server based algorithmic trading engines when building for the

future, regardless if we talk about the European or the US ETF market.”

If the European ETF market is at a make or break for its participants remains to be seen, but on a concluding note Griggs adds: “I think it is clear that there will be some sort of transition, whether it is driven by increased liquidity or a need to simply improve efficiency to stay competitive in the market. From our perspective, we feel that we are in a good position to capture a significant part of the mar-ket we expect will develop and we see the European ETF market as an opportunity going forward.”

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I think it is clear that there will be some sort of transition, whether it is driven by increased liquidity or a need to simply improve efficiency to stay competitive in the market.

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