[This interview previously appeared on IndexUniverse.eu.]

IU.eu: Laurent, what is the role of the ETF market maker?

Kssis: His main responsibility, once he’s signed a contract with the European stock exchanges, is to quote fair market bid and ask prices for the funds he’s obliged to deal in.

IU.eu: Aren’t these obligations with the European exchanges very broadly defined? In some cases the market maker can quote with a bid-offer spread of several percent and still be in compliance with the contract.

Kssis: They are broadly defined, but since there are typically several market makers involved with specific products, competition tends to drive spreads down to much lower levels. I always tell retail investors who are interested in a particular ETF not to look at the quoted trading volume, but to look at the number of market makers involved. Also, investors can look at the exchanges’ Web sites to get a feel for the trading liquidity. If you can see continuously quoted bids to buy and sell ETFs in round numbers, say in 10,000 shares, or 2,500 shares, that’s likely to be a market maker’s quote, and you know there is likely to be a fair market for that product.

IU.eu: But don’t European exchanges typically insist on a minimum of one market maker for an ETF, and if there is just one wouldn’t that affect the competitiveness of price quotes?

Kssis: That is true, although the exchanges and the ETF issuers have an interest in more market makers becoming involved with particular funds, as that helps to improve the efficiency of the secondary market, which will in turn attract more investors. But there have undoubtedly been cases in the past where there was only one market maker involved with a particular ETF, and where the ETF secondary market quote was, as a result, less competitive than the quotes for the underlying securities. Investors can check the number of market makers for a given ETF on the relevant exchange Web site, or on the issuer’s Web site, or both.

IU.eu: What other functions does a market maker fulfil?

Kssis: The most important role the market maker has is in the creation and redemption process for an ETF. Most ETF investors have heard the terms “creation” and “redemption”, but it’s quite a complicated process, which involves trading a basket of securities, putting up collateral, and a large amount of leverage from the point of view of the market maker. The creation or redemption is timed to coincide with the index provider’s calculation point, which is usually at the end of the day, but can be at any time.

Most investors, though, don’t need to concern themselves with this actual process too much.

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