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In The Engine Room
By Paul Amery | June 09, 2009

Related ETFs: LQD

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[This article previously appeared on IndexUniverse.eu.]

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How an exchange-traded fund trades can be nearly as important as the index it is designed to track. After all, it does you no good to identify an index that outperforms a cap-weighted benchmark by 1% per year if it costs an extra 2% to buy and sell the fund.

The group in charge of determining how ETFs trade are the “market-making firms”—traders tasked with maintaining two-way price quotes throughout the day in all of Europe’s 700+ ETFs.

Little-known by comparison with exchange-traded fund issuers, these market-making firms perform a vital service, ensuring that ETFs and other exchange-traded products fulfill their key characteristic of tracking the underlying securities’ net asset value. Indeed, one leading European ETF issuer told me recently that understanding how the market makers operate is the key to understanding the whole exchange-traded products business.

But who are these firms, and what influences their pricing of ETFs and ETCs? More practically, what can we learn from understanding how these firms operate that will help us trade better? IndexUniverse.eu spoke last week to several leading market makers to find out.

Who Are The Traders?

Some of the key traders are market-making firms like Flow Traders, Nyenburgh, Susquehanna, Labranche, Timber Hill, Saen Options, IMC, Madison Tyler, Geneva Trading, All Options and Optiver, many of which are privately held companies, often with a background in options and proprietary trading.

The “delta-one” desks of banks such as Unicredit, Morgan Stanley, Societe Generale, Deutsche Bank, UBS, RBS, JP Morgan, HSBC, Citigroup, and Goldman Sachs form another important group of market makers, since they have long-standing relationships with the institutional clients who are the main buyers of ETFs.

The first list of firms has traditionally operated as principals in the trading arena, buying and selling for their own account, while the banks have tended to focus on client business as agents or brokers. Recently, however, these distinctions have blurred, with several market makers moving to deal directly with investing institutions, and the banks trading for their own account as well.

There is also a significant overlap between the trading firms’ roles as Authorised Participants (“APs”) to ETFs (which makes them able to create and redeem ETFs in the primary market, and is set by agreement with the ETF issuers) and their role as official market makers, which is a contractual agreement with the exchanges on which the ETFs are listed, and subject to published obligations regarding the maintenance of minimum quote sizes and maximum dealing spreads.

In practice, a firm that signs up to the responsibilities of an official market maker will tend to be an AP as well, since this guarantees that it can use the ETF creation/redemption mechanism, where necessary, to make large trades.

What Influences an ETF’s Secondary Market Price?

The secondary market bid-offer spread for an ETF is influenced by a number of factors, but a major one is undoubtedly the liquidity of the underlying securities. Benjamin Fussien, head of ETF sales and trading at Societe Generale in Paris, showed at the recent EDHEC conference in Paris that average trading spreads on large-, mid- and small-cap equity ETFs in Europe doubled during September and October last year, reaching nearly 50 basis points for small-cap funds and nearly 20 basis points for large caps. This, in turn, reflected the dramatic rise in overall market volatility, which caused market makers to widen their quotes. While spreads have since contracted somewhat, they remain above pre-September levels.

As we reported on Indexuniverse.eu in October, a much more extreme spread widening took place in corporate bond ETFs, with double-digit discounts to reported NAV appearing on some funds. According to Roger Hodenius, managing director at Amsterdam-based Flow Traders, the cost of creating or redeeming the iShares $ Investment Grade Corporate Bond ETF (NYSE: LQD) exceeded 10% at the peak of the market panic, meaning that the “official” prices that made up the fund’s indicative net asset value did not reflect reality.

While the impact of such market events would affect all investors, other factors can affect an ETF’s secondary market price. These include the effect of any local fees or taxes in a given European market on the cost of an ETF creation or redemption, the cost of hedging when the underlying market is closed (more on this below), and any implied foreign exchange conversion, which would apply when the fund’s trading currency is different from the typical currency denomination of the underlying asset(s). The location where the trade is placed can also be important.