|July 10, 2012-|
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From a European perspective, the current transatlantic debate over whether market makers should receive direct incentives to quote prices in exchange-traded funds seems odd.
In the US, paying traders to support ETF liquidity is both controversial and legally problematic. In Europe, however, it’s not only permissible for ETF issuers to pay market makers, it’s long been the norm for fund providers to view this as part of the costs of doing business. In fact, European ETF issuers tend to dip into their marketing budgets for cash to keep trading firms quoting tight prices.
In April the two major US stock exchanges, Nasdaq and NYSE Arca, filed papers with the US Securities and Exchange Commission (SEC), requesting permission for exchange-traded fund sponsors to pay market makers for “going the extra mile” and ensuring that funds trade with adequate liquidity.
Under rules dating back four decades, such incentives are not allowed. In 1975, the National Association of Securities Dealers, a self-regulatory organisation, expressly prohibited its members from accepting cash for market-making on the grounds that this would distort the market.
“Payment by an issuer to a market maker would...undoubtedly influence, to some degree, a firm’s decision to make a market and thereafter, perhaps, the prices it would quote. Hence, what might appear to be independent trading activity may well be illusory,” the NASD wrote.
In 1997, the SEC gave this position formal backing, arguing that any such payments “would harm investor confidence in the overall integrity of the marketplace”.
Some US market participants are now pushing for the current prohibition to be ended, at least for ETFs.
“ETFs are priced and traded differently compared to common stock, but are forced to trade by the same rules,” Richard Keary, principal at Global ETF Advisors, said in a recent interview with IndexUniverse.com. “It’s like trying to put a square peg into a round hole.”
But one market heavyweight has spoken out against a hasty move to change the rules.
Vanguard, the third-largest US ETF issuer, has queried in two public comment letters to the SEC (here and here) whether incentive payments would benefit anyone except short-term traders in ETFs. Opposing NYSE Arca’s incentive scheme, Vanguard wrote in June that “exceptions to [the current] prohibition...should be made only if the rationale is compelling...such as providing demonstrable benefits to long-term investors.”
Issuers typically contract with traders to maintain bid-offer spreads on their funds within certain limits and to provide such quotes for a minimum percentage of exchanges’ continuous trading hours. The obligations set under such bilateral agreements are usually tighter than those mandated by the exchanges themselves (for more detail on the requirements placed on ETF market makers by European exchanges, see our feature article, Mind The Gap).
It makes sense, say several issuers interviewed by IndexUniverse.eu, for them to have a way of incentivising market makers directly, particularly as product development is leading issuers into less well-trodden areas of the market.
“For issuers looking to launch a new product, the job of getting market maker support is getting tougher and tougher,” says Kris Walesby, head of capital markets at ETF Securities. “Most of the well-known indices are already tracked by established funds and providers are getting into more esoteric areas. Issuers should be allowed to make their own decisions on how to incentivise liquidity providers.”
Having a direct commercial relationship with market makers also allows issuers to exert pressure on traders to maintain their price quotes if markets get difficult, adds Walesby.
“If we see that a market maker in one of our funds has temporarily stopped quoting prices, our ability to influence them to return to the order book is as strong as the relationship we have with them,” he says.
“Market makers have to take risk to quote prices in ETFs, and they need to carry inventory to meet client orders, which means they pay fees on the funds they hold,” says Ted Hood, chief executive of Source.
“It used to be the case that market makers would sign up to making prices in 500 funds, knowing they’d only trade actively in 50 of them. In fact, market makers used to queue up to trade in ETFs and offer seed capital to get them started, particularly in the US,” says Hood.
“But in the last two or three years trading volumes have gone down, the cost of capital for market makers has gone up and competition among traders has increased,” Hood adds. “So it’s not unreasonable that market makers are requesting payments to offer liquidity. I think it’s ultimately the responsibility of issuers, though, to ensure that their products are tradeable on exchange in a reasonable size, at a reasonable spread and on a continuous basis.”