According to a new report by Deborah Fuhr, Lyxor—along with Deutsche Bank and Barclays Global Investors—now controls a majority of the European ETF marketplace. To find out the latest of what's going at Lyxor, IndexUniverse.com recently talked to Dan Draper about his views of this evolving market.

IndexUniverse.com (IU): So far this year we've seen some modest growth in European ETF assets, compared to a fairly static picture in the U.S. What are your thoughts on the current state of the European ETF market?

Dan Draper (Draper): If we look at things in terms of an industry life cycle, Europe is still at the later-pioneer stage, whereas the U.S. market is at a later—though still growing—phase.

In the U.S., by some estimates, over half of last year's asset growth was from retail investors (or some form of aggregated retail funds). So in the U.S., ETFs are becoming a consumer-type product.

With the credit crunch highlighting the low level of savings—and U.S. ETFs having to compete with other, discretionary savings products—there is a squeeze on available funds.

On the other hand, the market penetration of ETFs in the overall pool of discretionary, managed assets is still extremely low. So there's plenty of room for growth. The next stage of the growth cycle in the U.S. will depend on the pension sector, including 401(k)-type plans.

In Europe, we still have a significant number of what I'd call "plumbing" issues, and so I find it amazing that we've had the growth that we have seen. Consider the fact that you've had multiple stock exchange listings across Europe, which fragments listed trading demand.

One of the biggest issues is multiple clearing and settlement systems: Clearstream in Germany (which is part of Deutsche Boerse); Euroclear in Belgium (which is partnered with Euronext); and Monte Titoli in Italy. In the U.S., the DTC operates one big, homogeneous market.

ETFs are by nature an arbitrage product. This is the basis of their attractiveness to investors. If an investor buys an ETF in Germany and wants to sell it in Italy, there are different settlement periods and potential problems with fungibility. The settlement systems are extremely profitable for their exchange owners, and this has prevented attempts to consolidate and merge across Europe so far.

Take into account also that most European ETF demand remains largely institutional and that the retail sector penetration hasn't yet taken off.

There are a couple of other factors I might mention, which have helped growth.

We're beginning to see the formation—especially in Germany, France, UK, Italy—of more multi-asset class funds of funds, using ETFs, often aggregating the assets controlled by financial advisors.

Also, since the credit crunch started last year, the European equity swaps market, which has always been more developed than in the U.S.—and was always a big competitor for ETFs—has become less attractive. Some players have pulled out completely and the pricing is becoming less competitive, as banks have to pass on their higher cost of capital. So many hedge funds, who have been big users of equity swaps, usually trading with their prime brokers, are now starting to use ETFs more actively.

We've noticed an increase recently in interest in equity sector ETFs, which had been slow to develop in Europe, when compared to the U.S., where they've been a boom market.

IU: Returning to the "plumbing" issues for a second, what can be done to improve secondary market trading liquidity in some of the cross-listed European ETFs?

Draper: Unfortunately we don't have as many listed market-makers in Europe as in the U.S. A lot of the bulge-bracket investment banks prefer to make markets over the counter and not commit to listing—for various reasons.

There are a lot of specialist arbitrageurs out there to correct price discrepancies, but they are servicing the banks more than the end clients. The underlying liquidity is there, but it's so much less transparent than in the U.S., so it is a big issue at this stage. But a lot of the banks are now beginning to merge their index arbitrage units with their program trading units, which will improve price competition.

They are also shifting resources away from proprietary trading to the more traditional business of servicing clients. This will also help ETF liquidity. And also, the securities lending market has been a lot more opaque in Europe, but that's beginning to improve as well.

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