Paul Amery, editor of IndexUniverse.eu, recently interviewed Manuel Schlabbers, head of European ETF trading at Credit Suisse.

IU.eu: Manuel, your trading desk covers all “delta-one” products. To what extent are investors now using ETFs, when compared with swaps, futures and other products offering index exposure?

Schlabbers: Historically, the European ETF client base has been dominated by asset managers and private banks. While they still form the major share of ETF users, we’ve seen an increasing number of hedge fund users of ETFs, particularly equity sector ETFs. Even though the majority continue to primarily use sector swaps because of their flexible nature and efficient cost structure, there are several hedge funds which have moved their sector trading to ETFs. This reflects the shift towards products with reduced counterparty risk since the Lehman collapse, but also an increased preference for investments that are exchange-traded. In the future, we also expect to see a significant pick-up in retail investor use of ETFs in Europe.

IU.eu: It’s been two years since the introduction of MiFID, the European Union directive that has led to a proliferation of new trading venues in Europe. Some welcome the increased competition and reduced trading costs, while others claim that transparency has been reduced. What are your views?

Schlabbers: The MTFs [multilateral trading facilities, many of which have been set up since MiFID – IU.eu] offer cheap execution and settlement services when compared to the traditional exchanges, although we haven’t yet seen a great deal of secondary ETF trading conducted on them. This may be because there are still relatively few ETF listings on MTFs. The two most widely traded ETFs on MTFs are the ISF (iShares FTSE 100) and the DAXEX (iShares ETF DAX), which have around 20-30% of their total trading volumes there, while for most others it is close to zero. As we expect a trend towards increased on-screen trading in ETFs in Europe (as opposed to trading on a bilateral, over-the-counter basis), we expect the share of MTFs to pick up over time. However, overall levels of equity trading on the MTFs have already increased – Chi-X has over 10% of European market share, for example. So when I execute a basket equity trade as a hedge for an ETF transaction, the end-client will benefit from the existence of these more cost-effective execution platforms through an improved price for the ETF trade.

As far as transparency is concerned, I suppose that the fragmentation of the European share trading market means that on-screen liquidity does suffer to some extent. The multiple currency denominations of some ETFs also make it difficult to compare prices across trading venues.

IU.eu: What general trends are you seeing in the way clients execute their ETF trades? Can you compare risk, agency, NAV and closing auction trades and what are the pros and cons of each route?

Schlabbers: First of all, we’re witnessing increased competition on the trading side which, together with greater investor interest, is leading to increased on-exchange trading volumes in ETFs and an overall reduction in bid-offer spreads. But while reported volumes have been growing, on-screen liquidity is still very fragmented. In Europe, on an average day around US$2 billion in reported transactions occur in the secondary market, compared to around US$40-60 billion in the US. So there’s still a big difference. However, these figures understate the true level of European trading activity, since the vast majority of European ETF transactions take place over the counter. Under MiFID, there is no requirement for post-trade reporting of these transactions.

Comparing the different routes of trade execution that you’ve mentioned, I’d say that in terms of numbers, around 70-80% of trades are done on an agency basis. This means that the ETF is traded directly in the secondary market (if the trade is below the creation/redemption size, for example), or by executing the underlying basket of securities in the market and then going down the primary market route (creating or redeeming ETF units with the issuer in exchange for the basket of index securities).

Agency orders allow the client to direct how the deal is executed and they generally tend to be cheaper than trading via a risk price (where I would have to charge a risk premium to the client for achieving immediate execution). The disadvantage for the client of an agency deal is that the client still bears the market price risk until the deal is concluded.

Risk trades constitute only 10-20% of our deals in terms of numbers, but maybe 50% by overall notional size. Clients like to trade “on risk” for larger-sized orders as they know the dealing price immediately. The disadvantage of this route is that the broker will charge a risk premium, as I’ve mentioned.

Trading at the closing net asset value of an ETF is popular, since this is a very transparent route. However, trading at the closing NAV means that you’re not taking advantage of the intraday liquidity of an ETF, and you’re still exposed to market movements from the time you place the order to the time of the NAV calculation. This route is most popular for those clients who have a long-term investment horizon, perhaps several months or even years.

Trading at the closing auction price of the ETF itself is usually a bad idea for European-listed ETFs due to the relatively wide dealing spreads involved. So, unless you’re trading in one of the 10-15 most liquid European ETFs, I’d advise against taking this route.

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