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January 20, 2014 2:33 pm
In the global hunt for return, you would be forgiven for thinking that investors around the world would be united in their appetite for low-cost, transparent solutions that generate income, particularly if they could pay lower management fees.
But a cursory glance at the global exchange traded funds market suggests that this is not the case. In the US, SPDR’s S&P 500 ETF has become the largest in the world, sometimes trading more than the value of the entire European equity market. There are 1,259 ETFs domiciled in the country and more than $1.6tn assets under management.
In Europe, the draw for investors seems less strong. The UK’s retail distribution review which took effect at the end of 2012 has not prompted the apparent explosion in investment that the industry initially anticipated, and there are wider concerns that the benefits of ETFs are not fully understood by retail investors. Something in European ETFs simply isn’t working.
It is not an issue of demand. Inflows are building – at the end of December 2013, European ETF assets under management amounted to $395bn, up 19.3 per cent, in 1,377 ETFs (5,021 listings). This growth is positive: ETFs provide low-cost single connection access to a range of asset classes, geographies and indices that traditional funds cannot.
Neither are these problems the fault of a long-term trend. As more European investors take on management of their pension through defined-contribution offerings, many are likely to look to ETFs as a precise instrument to access a wide range of investment choices, at a lower price.
Instead, we believe it is the ETF marketplace – not the products themselves – that is not yet fit for purpose. In Europe, liquidity is split between no fewer than 24 exchanges, and providers must list the same product in a handful of markets in order to appeal to a smaller investor community. This fragments liquidity further, creating unnecessary frictional costs and pushing potential investors towards more traditional investment vehicles.
Five simple steps – split between issuers, investors and exchanges – could reform market structure and realise the opportunity.
First, we must improve on-exchange liquidity. This can be done by incentivising price formation. Effective market making will tighten spreads and add depth, attracting further investors and in turn more market makers. This creates the essential liquidity cycle.
Second, under the first version of the Markets in Financial Instruments Directive, European participants are not required to report their off-exchange ETF trades, even though off-exchange ETF activity is as much as 70-80 per cent greater than that of equities.
A lack of price transparency and the number of cross-listed ETFs makes it difficult for investors to be sure they are trading at the best available price. Until Mifid II addresses this issue or transparency is voluntarily addressed by the industry, it will remain elusive.
Third, cross-listing ETFs on multiple exchanges is commonplace among issuers, in part to appeal to domestic and regional participants. However, these multiple listings are creating a more complex and costly product and are not necessary in the EU for regulatory or legal purposes. This in turn forces market makers to split their risk capital, reducing the potential liquidity available in an ETF which makes it difficult for customers to determine where the best price is available.
This cycle discourages investors from participating as actively as they might wish. By trading the same security across Europe, investors can avoid this problem.
Related to this, imagine if each ETF, like equity shares, was issued and settled in a single location. The risks and costs of cross-border settlement would be removed. The solution could exist in a national central securities depository or an international CSD like Euroclear Bank. The latter already performs this role for other pan-European instruments such as depository receipts and eurobonds with national CSDs settling inside Euroclear Bank and providing the same settlement services to their customers as they do when operating domestically.
Finally, exchanges can and should work in tandem with issuers and market participants to boost transparency and bring listings and pools of liquidity together. The industry still needs to do more to address issues concerning transparency, liquidity, and risk. This is the only way we can build a European ETF market that is more efficient and grow volume and assets under management.
Fulfilling these primary goals will attract participants to a market in the early stages of growth and better serve Europe’s investors in the long term.
Mark Hemsley is the chief executive of BATS Chi-X Europe
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