US regulators have approved plans to improve the liquidity of the US exchange traded funds market.
The Securities and Exchange Commission has agreed that NYSE Euronext, the exchange operator, can allow ETF managers to pay market makers in order to encourage them to offer competitive price quotes for US listed exchange traded funds and products.
The exchange said it was launching the scheme because current incentives to serve as a lead market maker for an exchange traded product might be “insufficient” to outweigh the obligations and risks they faced.
Lead market makers are held to higher standards than other market participant because of their important role in providing liquidity and ensuring orderly trading.
“Payment for market making is an interesting development. If it helps new ETPs attract assets, because trading costs are lower, that’s a good thing for ETP market diversity,” said Phil Mackintosh, global head of trading strategy at Credit Suisse.
The NYSE Arca Exchange Traded Product (ETP) Incentive programme will launch in the second half of 2013 and run as a pilot scheme for 12 months.
Under the scheme, fund managers can choose to pay between $10,000 and $40,000 a year per exchange traded product to NYSE Euronext. The exchange will then pay the lead market maker if they exceed their “quoting requirements” for that ETP.
Managers will be able to chose up to five existing ETPs to take part in the scheme as well as any new products that are launched during the pilot programme. More liquid ETPs that trade more than 1m shares over the past three months of trading will not be eligible and neither will any ETPs where creations and redemptions have been suspended.
Lead market makers will be assessed on a monthly basis to see if they have met the exchange’s requirements to post competitive bid and offer prices along with offering trades of sufficient size to meet certain liquidity standards.
Trading spreads on thinly traded ETFs (that trade less than 10,000 units a day), which do not have a lead market maker, have ballooned over the past two years to average 11.5 per cent in the final quarter of last year. Spreads for thinly traded ETFs that do have a lead market maker have remained fairly constant at around 0.8 per cent over the same period.
Such a large difference in spreads could be an important factor in deciding whether to trade one ETF or another.
Mr Mackintosh noted, however, that be wider trading spreads on an ETF did not necessarily imply that the market was uncompetitive.
“Sometimes spreads just reflect the higher cost of making markets in less liquid ETFs, such as the cost of holding inventory when building creation baskets, and the lower economies of scale when doing single unit creations versus multi-unit creations”.
Mr Mackintosh cautioned that the new scheme might lead to higher ETF management fees as well as acting as a greater drain on the cash of new entrants.
Shawn McNinch, global head of ETF services for Brown Brothers Harriman, said it made sense to provide proper incentives to lead market makers but it was unclear if smaller ETFs would be willing or able to pay in the hope of seeing tighter spreads.
“It will be very interesting to see how many ETF managers sign-up for the programme,” said Mr McNinch.
“The key point is that nothing is free,” said Mr Mackintosh.