Mark Esposito, president of Dallas-based Esposito Securities, is a new breed of ETF seed capital provider. Instead of putting up money to start ETFs in exchange for working as the lead market-maker on the new fund, Esposito takes a fee and seeks to build long-term relationships with fund sponsors he works with.

When he recently spoke with IndexUniverse’s Steve Dew, Esposito made clear that as high-frequency trading squeezes market-maker profits and diminishes the role of specialists, it's possible that more ETFs will come to market using seed money from firms like his.

Dew: The Pax World products you helped seed are interesting. How did you get started seeding ETFs?

Esposito: I started at J.P. Morgan, then Southwest Securities and started Esposito Global five years ago. Throughout my tenure on the Street, it was clear that there was an underserved need—underserved by the big firms—for specialty institutional products and services. The big guys weren't willing to create customized services such as one-off algorithms or work with custom file formats, etc. All the big firms have white-label products, but they would never tweak it for small- to midtier players.

That's where Esposito’s value-added business model was shaped, by providing the extra layer of products and services. Last year, seed capital on the Street contracted based on market conditions, and we got a call for help in this area because the Street understands that Esposito is set up to help them grow. We thought this could be an interesting proposition for our firm to help grow the ETF industry.

Seed capital used to be free. But now, fund sponsors either have to pay for it or play for it. We've seeded six or seven funds. The consensus is that seed money is still tight, capital is expensive and there's a limited number of players. That's how seeding came to be part of our fast-growing ETF franchise.

Dew: How do you think the seeding area of the ETF world has changed, and did the “flash crash” on May 6, 2010 have anything to do with those changes?

Esposito: I think the landscape has been changing for years and always will. I don't think May 6 helped any, and I think that was coming either way. High-frequency traders have caused problems for seeding. A lot of people that seed rely on lead market-making and making a spread to cover costs and make a profit, and we don’t do that. The tighter the high-frequency guys get, the less the lead market-maker can make, theoretically. And with what happened on Wall Street financially in 2008, no one wanted to put out capital. And, it is raw capital.

What would be ideal would be for the issuer to find an end-user to seed, an actual investor who wants to hold the security indefinitely.

Seed capital lead market-making is a loss leader in a lot of cases. So, unless you're doing business with other parts of the firm, and you're looking at seeding as part of an overall relationship, it's hard to justify as a stand-alone business, because you could get hurt.

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