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The European market for exchange traded funds is still adjusting to a transformative event that could come to be seen as the making of it: the arrival last year of the vast piece of legislation known as Mifid II.
Seven years in the making, the directive was billed as the biggest shake-up to hit European financial markets in more than a decade and came into effect in January 2018.
Its provisions covering the ETF market are profound. Europe had long lagged the US, where the biggest funds are as actively traded in terms of volume as stocks and are popular among retail investors. Indeed, ETFs typically account for nearly a fifth of all US equities trading, according to Fidelity, the fund manager.
The previous insignificance of ETFs to EU regulators was reflected in the original Mifid directive of 2004 by one stark fact: it did not recognise the funds as an asset class and worthy of transparency.
The financial crisis of a decade ago changed the landscape. A spotlight was turned on hitherto opaque markets. Since then, the loose monetary policies of central banks have helped create a bull market in equities and a boom in passive investing that saw ETF investing explode.
Mifid II has attempted to adjust to the modern market and demands transactions be reported rapidly and in detail.
“It’s the most fundamental change to ETF trading in my lifetime. The European ETF market has really come of age,” says Jason Warr, head of global markets in Europe for iShares, the ETF arm of BlackRock, the asset manager.
While many banks and exchanges have suffered from becalmed stock and bond markets, BlackRock estimates ETF trading volumes were $1.44tn in the first half of 2019, up 35 per cent year-on-year. That compared with $533bn for all of 2017. The growth in ETF trading came in spite of a relatively muted growth in assets under management by these passive funds, which rose from $802bn to $893bn over the first half of the year, according to data from FactSet.
Part of the reason for the higher reported turnover of deals is that more of the market is rapidly shifting away from being opaquely traded over the phone — another practice Mifid has attempted to tighten up on.
An irony of the market in ETFs before Mifid II took effect was that most were in fact not traded transparently on exchanges. Rough industry estimates suggest about 70 per cent of deals were negotiated privately over the phone, in contrast to many modern electronic markets.
Europe’s ETF market also shows signs of succumbing to the trend towards automated, digital operation. More trading generally is being done by computers and algorithms that decide where, when and how to trade.
Tradeweb recorded its third-best quarter for European ETF trading in June, transacting a notional €28bn. However some 65 per cent of that total was via a tool that can automate deals according to the customers’ instructions.
The shift has also been aided by some quirks in the rules. If a trade was executed in a transparent electronic marketplace, then reporting trades — a major compliance headache — was the responsibility of the venue. Mifid has been a major shot in the arm to venues such as Tradeweb and the London Stock Exchange because they can take on the compliance task.
These forces in turn have pulled in more institutions willing to trade in exchange traded products. Flow Traders, the Dutch ETF market maker, estimates the number of market participants wanting quotes from the company rose from 790 in 2017 to more than 1,000 last year.
This increased participation is boosting liquidity across the market. BlackRock says the first fixed income ETF to trade over $1bn in a day was a fund that tracks the performance of euro-denominated investment-grade corporate bonds.
Exchange traded products are also becoming more integrated with other markets activity, such as securities lending. Institutional investors are relying more on ETFs in bond markets because they can be more easily bought and sold than the bonds themselves.
As an example of their growing use, Adriano Pace, head of European equities at Tradeweb, points out that many investors used ETFs as a way to increase their exposure to Saudi Arabia when the country was included in MSCI indices this year. The move led to the reallocation of hundreds of millions of dollars of investors’ money. “Investors are getting more comfortable using ETFs,” he says.
Even so, there are frustrations. BlackRock has previously complained that investors only get a partial view of the market and many institutions have called for “consolidated tape”, a single record that aggregates information about deals that have been completed, including their size and price, to protect customers’ interests.
Some commercial services exist, such as the one operated by Bloomberg that is limited to subscribers to its bespoke terminals. European watchdogs are examining the provision of market data amid complaints of ever-rising prices.
Esma, the regulator, has launched a consultation on tapes that would cover equities, bonds and ETFs. Meanwhile, Europe’s appetite for exchange traded products shows no sign of abating any time soon.
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