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Exchange-traded funds have revolutionized investing and markets in ways we never could have imagined. ETFs fill the investing pages of the Wall Street Journal and stream across the ticker line on CNBC all day long. With all of the attention ETFs have received, however, few investors truly understand the complexity of what goes on behind the scenes with ETF trading and market making. There is a diverse array of players in the market that is truly the key for making ETFs the efficient windows into market liquidity that they are.
To understand how the market for ETFs works, let’s take a step back and talk about how an ETF works. ETFs are effectively mutual funds that trade like stocks. But unlike stocks, where price discovery is a function of supply and demand throughout the day (i.e., scarcity of shares and opinions), an ETF is a collection of securities whose underlying valuation can be calculated as a result of the portfolio’s transparency. This transparency, coupled with the ETF’s creation redemption process, creates a constant loop of pricing information that is used to create an arbitrage opportunity should the fund’s price get out of line with its expected underlying net asset value (NAV). As the supply and demand for an ETF goes up and down, authorized participants exchange the basket of underlying securities for the shares of the ETF to increase or decrease the ETF shares available in the marketplace. Thus, generally the price discovery of the ETF is not affected by long-term supply and demand, because the size of a fund’s assets under management can grow and shrink according to demand.
Sources Of Liquidity
There are a variety of exchanges and trading venues that can be generally characterized as 1) the listed exchange utilizing either the lead market maker (LMM) arranged by the exchange (U.S. approach) or arranged by the issuer (common European approach); 2) multilateral trading facilities (MTFs) with unlisted trading activity; and 3) alternative liquidity aggregation venues, often called “dark pools,” that do not expose an order to a public quote. Liquidity providers and liquidity takers meet on these trading venues in a process known as price discovery. The basic idea is that through price discovery, liquidity providers are fundamental to ensuring that ETFs trade at values close to their expected NAVs, throughout the trading day. But regardless of who is providing the liquidity, understanding the finer points of exactly how that liquidity provision is introduced to the exchange is key to understanding how this market functions.
At the heart of the exchange model, these players are known as lead market makers. LMMs are akin to designated market markers (formerly known as specialists) in the floor-based trading system. Operating in a fully electronic market model, LMMs support displayed limit order trading because they are obligated to quote narrow, two-sided markets throughout the trading day. LMMs are responsible for maintaining share depth, tight quoted spreads, and using publicly displayed limit orders to generate the opportunity for price improvement. The LMMs enhance market quality and supplement natural liquidity from the collective broker-dealer community.
Academic research supports this point. An article titled “Paying for Market Quality,” by Anand, Tanggaard and Weaver published in the Journal of Financial and Quantitative Analysis (JFQA) in April 2008 reports on the benefits of liquidity providers (referred to as “LPs” in our European markets, which are akin to our U.S. LMMs): “… price discovery during the continuous trading period of the trading day increases significantly following the start of LP services.” Another white paper, titled “The Value of the Designated Market Makers,” by Venkataraman and Waisburd published in the JFQA in September 2007, indicates that: “A dealer enhances market quality by simply maintaining a regular market presence.” The research goes on to say that a market maker “reduces price risk that equilibrium values may shift between order submission and execution.”
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