Reported ETF trading volumes in Europe lag far behind those in the US – by a factor of 30, according to some specialists. But though it's long been considered the poor cousin of its transatlantic relative, the European ETF industry may be about to come in from the cold as far as trading is concerned. Work is underway at both the European Commission and European Central Bank that could clear the path for a consolidated tape and best bid-offer system for ETFs, similar to those available in the US.

Mark Howarth, interim chief executive of Chi-X Europe, a multilateral trading facility, said he expected the current review of the Commission’s Markets in Financial Instruments Directive (MifId) to require traders to feed all ETF trade details – including, most significantly, the 70% or so that occur unreported (“over the counter" or OTC) – into a consolidated post-trade tape. “The implications of this are quite significant,” said Howarth. “It will have far-reaching effects. For the first time institutional investors will be able to make absolute comparisons between several providers.”

Howarth expects that a consolidated tape, showing price, size and venue for all trades in the European ETF market, will lead in turn to a best bid-offer system in European ETFs, under which traders must route orders to whichever venue, wherever it might be in Europe, that offers the best price. “There will probably be no requirement to do a best bid-offer under MifId,” said Howarth. “But there will be a requirement for a consolidated tape and by default you will start to have a best bid-offer based around a consolidated tape. As the market moves to consolidate there will be a push to a best bid-offer situation.”

Under the present system there is no requirement to publicise the details of ETF trades in Europe that take place away from official trading platforms. This anomalous situation has led to deceptively low volumes of reported ETF trades, which has the Catch-22 effect of deterring many potential investors from venturing into markets they perceive as less liquid than they really are.

MifId authorities are under pressure from the ETF industry to revisit a decision to exclude ETFs from the first version of the directive. If ETFs are included in future versions of MifId, traders would be required to report details of the 60-75% of invisible ETF trades that occur over the counter. The impact of making these OTC trades public would be to give potential and actual ETF investors a more accurate picture of European ETF volumes, and one that is less likely to deter them from investing.

A consolidated tape is also likely to lead, either directly or indirectly, to tighter spreads for all investors, including individual retail clients, since it would theoretically require the terms of all trades to be made public. Retail investors are more likely to deal on better terms if their orders are placed on the same electronic trading networks as larger orders, as already happens in the US.

Essential to the development of a European best bid-offer is the challenge known as “clearing interoperability”. This is the complex – in both political and technical terms – task of linking up the so-called ‘back ends’ of trading platforms in different countries. Through a project known as Target2 Securities, coordinated by the European Central Bank, work is already underway to harmonise settlement platforms. The goal is to create a system in which, for example, an investor could buy an ETF on a German exchange but settle it in Milan, or wherever he chooses.

“There is a project that intends to link the back ends of all the different European trading venues, so it doesn’t matter where you trade,” said Bart Lijnse, managing director at Netherlands-based ETF market maker Nyenburgh. “It won’t matter where you buy, it will all end up in the same pool.”

Currently, cross-border European transactions are more complicated and costly than those undertaken within a single country. Target2 Securities is aimed at making settlements across national borders simpler and more cost-efficient.

Among the implications of Target2 Securities is a potential reduction in the number of cross-listings for European ETFs. A proliferation of listings for the same product has the effect of further fragmenting already limited liquidity. However, fewer listings could be bad news for the exchanges themselves, which derive some of their income from listing fees for ETFs. “I don’t see the exchanges giving up their independence but there will be more harmonisation between trading communities as to where they transact their ETF trades,” said Howarth at Chi-X Europe.

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