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Gerry Turner
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Pressing the PaaS Button

In his latest blog post, Gerry Turner, Global Head of Platform as a Service at Vela, discusses how forward-thinking firms are now looking at derivatives platforms in a new way and exploring the cost/benefit equation of the PaaS approach.

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June 18, 2008

Sweetening the Pot

By James Ramage

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Currently, there is just one designated liquidity provider for each of the 28 Nasdaq-listed ETFs that have them. The new payout affects 28 of Nasdaq's 29 listed ETFs. Only the ultra-liquid Qs-PowerShares QQQ Trust-trades over the 10-million-shares ADV threshold.

The market makers who have signed up to be "designated liquidity providers" with Nasdaq so far include Timber Hill, Goldman Sachs Execution Services, Susquehanna Investment Group and Sun Trading.

On the NYSE and Amex, LaBranche & Co., Goldman, Kellogg Capital and Susquehanna are the big players.

What's in It for Specialists?

Nasdaq's rule change comes at a time when profits for those market makers who seed capital for new ETFs continue to decline dramatically.

Formerly, specialist firms would provide seed capital for ETFs in return for prime exposure to the order book. With a good idea behind the ETF, as well as the right placement and proper demand for it, the market maker could use his advantageous position regarding order flow to earn back that seed capital quickly en route to profits.

As the markets for trading ETFs have increasingly gone electronic and spreads have narrowed, lead market makers' advantages and profits have shrunk. Thus, there is less incentive for specialists to fund ETFs that likely will produce few opportunities for them in return.

But ETF industry insiders are mixed about what Nasdaq's move will achieve for specialists.

According to a market maker in the industry who does not want to give his name, Nasdaq's move is a step in the right direction, but will likely achieve little to encourage dealers. There is a need, he says, for new thinking on how to fund ETFs that should not necessarily be dependent entirely on specialists.

But a higher liquidity rebate makes a difference for Vaidas Uzgiris, head of ETF trading at Greenwich, Conn.-based Timber Hill, the proprietary division of Interactive Brokers. Without addressing Nasdaq's move specifically, he says a high rebate is a strong incentive for specialists at the firm.

"Making the specialist position more desirable means more people would be willing to provide money for [new ETF] seedings," Uzgiris says.

Wanted: Better Ideas

But higher rebates aren't the primary issue, according to Lisa Dallmer, senior vice president, ETFs and indexes, at NYSE Euronext. The problem lies in the low demand for certain kinds of ETFs.

When seeding an ETF, specialists have both fixed and "carry" costs, she says. And if the specialist wants to use trading revenue to offset those costs, he must have an expectation of specific ADV trading revenue. This becomes a problem if too many new ETFs are fourth-to-market products, or worse, they lack sufficient demand, Dallmer says.

"We can't expect transaction fees to completely be an offsetting revenue source against seed capital in its entirety," she says. "You need that demand, that pull, from the distribution channel, from the retail marketplace. And if that is latent, or if that requires some build, then that means that whoever seeded the fund has some carrying costs for a while."