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September 1, 2012

Debate Rages On ETF Sponsorship

By James Armstrong

If issuers of exchange-traded funds could pay to attract market makers to their products, would there be more liquidity in ETFs? Or would paying market makers create a dangerous precedent and harm long-term investors?

Both Nasdaq and NYSE Arca have proposed programs allowing ETF issuers to pay fees to the exchanges for market-maker support. The proposals are similar to a program already implemented on the BATS exchange, which has a handful of ETF listings.

These proposals, according to comment letters sent to the Securities and Exchange Commission, are drawing strong reactions from key industry figures.

Ari Burstein

The Investment Company Institute has come out in favor of the measures, arguing they could result in narrower spreads and more liquid markets. In a letter to the SEC, ICI's general counsel, Ari Burstein, said the organization has long advocated changes to increase the efficiency of markets.

"As ETF sponsors, ICI members have a strong interest in ensuring that the securities markets are highly competitive, transparent and efficient," Burstein said. "Liquid markets are critical for ETFs, particularly smaller and less frequently traded ETFs."

While Burstein stressed that regulators should start with a pilot program before introducing a major change to market structure, he said the exchanges seem to have addressed concerns that paying market makers might impact investor confidence.

Those sentiments were echoed by BlackRock, the nation's largest ETF issuer. Joseph Cavatoni and Joanne Medero, both managing directors at BlackRock, wrote a joint letter to the SEC stating that current programs often do not provide a sufficient incentive to attract market makers to new exchange-traded products.

"The exchanges' respective proposals and plans offer the opportunity for new and smaller ETPs to gain traction in the marketplace at an earlier time," they wrote. "The exchanges should be allowed and encouraged to experiment and innovate unique programs."

Cavatoni and Medero emphasized, however, that incentive programs should benefit shareholders, not merely subsidize market makers. That is the fear of many in the industry who have been critical of the proposals.

Vanguard, the mutual fund giant which also offers a number of ETFs, said it neither supports nor opposes the Nasdaq proposal and certainly does not support the NYSE Arca proposal, at least as it is currently structured.

In a letter concerning Nasdaq's ETF initiative, Vanguard chief investment officer Gus Sauter said payments to market makers have the potential to distort the markets and create conflicts of interest. Though Nasdaq proposed several safeguards to prevent that from happening, Sauter suggested a longer review and comment period would be a good idea.

Sauter had sharper words for the NYSE Arca proposal, claiming the exchange had focused on the needs of market makers, not investors. Noting that 90 percent of exchange-traded products on NYSE Arca already have lead market makers, he told the SEC that before it overturns long-standing rules, more should be done to require higher minimum-performance standards for market makers.

"We believe the commission should not approve the proposal until Arca articulates and provides support for the purported benefits to the markets and long-term investors that the program will provide," Sauter said.

Timothy Quast, managing director of the trading analytics firm Modern Networks IR in Denver, was harsh on the proposals as well. He told the SEC that paying market makers could constitute a racketeering felony. What is more, it would increase speculative short-term trading rather than focusing the markets on capital formation, he said.

NYSE and Nasdaq declined to comment. The SEC is expected to rule on the matter later this month.

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