Lisa Dallmer is senior vice president of  global exchange-traded products and index services at NYSE Euronext. She recently talked to Paul Amery, IndexUniverse's European editor, about the mechanics of European ETF trading, liquidity issues and competition amongst exchanges.

[Editor's Note: This article was originally published on IndexUniverse.eu.] 

IU.eu: What's the thinking behind the new single-order book process at NYSE Euronext, and how might it affect ETFs? What feedback have you had? 

Dallmer: For issuers, the new process will commingle liquidity pools. An issuer may have the same ETF listed on three or four different NYSE Euronext exchanges, and we found that there were distinct liquidity pools, which didn't necessarily interact with each other. For an investor, this will mean that there's a higher probability of accessing liquidity pools that they weren't aware of before. We think that both issuers and investors are happy with the new system. To the extent that investors want to maintain multiple European listings for an ETF—which they may wish to do in order to have a relationship with the relevant regulator, and to enable retail marketing - there will now be a single order pool for secondary market trading purposes in Belgium, France and the Netherlands. It's probably also worth mentioning that we're rolling out UTP—a universal trading platform—which is a way of connecting all major segments within the trading process.

IU.eu: Can you clarify whether US ETF providers can cross-list their funds in Europe, and European ETF providers in the US?

Dallmer: Currently one US ETF—the Diamonds—is cross-listed on NYSE Euronext Amsterdam and traded in Euros. Originally the listing was in US dollars, but the fund was relaunched in Euros in late December. The cross-listing was permitted under the Dutch regulatory environment, which recognises funds that are regulated and registered with the SEC. In the US, the regulation and registration of ETFs by the SEC is limited to US Registered Investment Advisers, so US law does not permit cross-listing of a non-US ETF within the United States. A European ETF provider that wanted to operate in the US would have to set up a physical presence there.

IU.eu: So, bearing in mind that US ETF providers can cross-list in Europe, do you expect them to do that, or to relocate here and build European-domiciled fund platforms?

Dallmer: We already have a few with a presence in both markets—for example, Barclays Global Investors, parent investment adviser for iShares; and Invesco, the parent company investment adviser behind the PowerShares brand. For other US managers, simply cross-listing ETFs in Europe will not guarantee that investors will be aware of a product, so it depends on how much they're willing to invest to gather European assets. US funds that are cross-listed will also not be UCITS-compliant, so this would reduce the potential investment pool that they might draw from. You also need to support funds from the point of view of education, product awareness and outreach to retail investors.

IU.eu: What is the likely impact of the new Multilateral Trading Facilities (MTFs)—for example, Chi-X, Turquoise—on the ETF market?

Dallmer: Just as happened in the US, we're seeing more competition from new trading platforms, which is always good for the marketplace. The new platforms have to invest in sustainable and efficient technologies, and they have to be able to support the various clearing channels. Some platforms have made some inroads, and we'll see how this plays out. The importance of a regulated marketplace, secured clearing and varied clearing models—these factors also impact where order flows head to.

IU.eu: We hear reports that market-makers are reluctant to seed new ETFs and are carrying lower inventories than before—won't this affect secondary market trading volumes, and what can be done about it?

Dallmer: Arbitrage players, and market-makers in general, are managing their inventory differently in this environment of financial crisis than before. Liquidity lines are tighter, and the short-selling restrictions from last fall have increased the cost of maintaining inventory and transacting. ETFs are no different from equities, and have been affected. It's become more difficult to borrow securities, and this has had a knock-on effect on the amount of inventory people are willing to carry. Spreads on equities have widened out and become more volatile, and ETFs—which are made up of the same equities—reflect this in their own spreads. I think things will improve as and when the liquidity crisis improves.

IU.eu: Are there any other changes you feel are necessary to the market-making infrastructure for ETFs, or in clearing and settlement systems?

Dallmer: Between the exchanges and those involved in trading, there are certainly high-level discussions going on about clearing interoperability. Currently, if you have an ETF listed, for example, on Euronext, but also another exchange, like Borsa Italiana, they would clear via different clearing systems and different central depositories. So a broker-dealer with a short position in one location and a long in the other faces a challenge: how to physically move the security, books and records to close out the position. This is one of the reasons why the European single order book project at NYSE Euronext was possible, because we dealt with Euroclear, and across the Belgian, Dutch and French markets, they collapsed into a single back-office system.

IU.eu: What other innovations might be undertaken to improve ETF secondary market liquidity? For example, could ETF providers print trades on exchange for free?

Dallmer: NYSE Euronext offers a mechanism to enter a cross-order on the central book, subject to certain conditions, and also a separate service called the Trade Confirmation System (TCS), which allows liquidity providers and member firms to bring a cross-trade. Both are useful mechanisms to articulate secondary volume in a particular product, especially in a public company stock, since there's a set number of shares, and this gives you a feel for turnover and liquidity. For ETFs, since they allow new creations and redemptions, share turnover is important, but you have the added reassurance that if you want to place a large trade, you could contact one of the authorised participants and work on getting a creation unit, thus increasing the shares outstanding. It's not free, but the cost of entering a cross-order on the central book or using TCS is relatively low.

IU.eu: How would you compare the overall secondary market liquidity for ETFs in the US and Europe?

Dallmer: Setting aside the sheer magnitude of the turnover in the US, I would say that, generally, it's very similar. In the US, the top 5 ETFs contributed 55% of the overall ETF market turnover during the fourth quarter. In Europe, the top 5 had a 49% share of the overall NYSE Euronext ETF market turnover for the same quarter. Incidentally, on NYSE Euronext in Europe, these were the Lyxor CAC 40 ETF (20%), the Lyxor DJ Euro Stoxx 50 ETF (15%), the SGAM CAC XBear (9%), the iShares EuroStoxx 50 (3%) and the Lyxor Short CAC 40 (3%).

In both the US and Europe, ETFs are a very efficient packaging mechanism for gaining whole-market exposure. A few broad index products dominate in each location. Having said that, not all ETFs are created the same, and not all have the same ease of secondary trading. The underlying index may have an ETF trading, there may be a futures contract and/or an index option. There is an arbitrage interplay when products have all these places to interact, and this tends to feed liquidity. Some ETFs are based on indices that are less tradable. These are designed more as access tools than for their underlying trading liquidity, and tend to have a more buy-and-hold profile.

IU.eu: What ETF product types/fund structures do you expect to grow most in Europe?

Dallmer: Most ETFs up to now have been long-only equity products, and after the 30-40% falls that we've seen, product providers are being forced to innovate to attract new funds, whether it's through new leveraged and inverse funds, or offering new commodity products. But I also think it's healthy to observe the market and to see what's working, and what's not working, and then to innovate to deliver more value to the investor, whether that is via greater collateralisation, or more transparency in what the index or the product holds, or whether that means closing ETFs that haven't gathered assets.

IU.eu: How important is the UCITS III model for European ETFs?

Dallmer: I think that UCITS III has obtained global recognition as a collective investment scheme model, and this makes it very transportable and useful.

IU.eu: How do you see your competitive position versus other European exchanges (both traditional and MTFs)?

Dallmer: Operating a regulated marketplace is an important standard for assuring investors that certain expectations about how things trade, and what trades, are met. All of the exchanges that operate in this way have incremental costs. We do our best to manage that incrementally higher service offering, and we compete with the MTFs and the other, traditional exchanges too. Every one of us is looking at how to streamline technology, how to harmonise processes, and how to make connectivity accessible and cost-effective for the member firms. NYSE Euronext is rolling out something called the Common Customer Gateway, which are common connectivity protocols for member firms. Ultimately, also, the internal cost savings we're creating will be passed on to our member firms.