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Tim Quast
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May 1, 2013

Fund Fight

Nasdaq, NYSE and BATS are slugging it out with incentives, new order types and a new exchange to resuscitate trading in ETFs

By Tom Steinert-Threlkeld

Once it worked. Now, not so much.

For years, the Nasdaq Stock Market designated a single market maker for each exchange-traded product. Later, the BATS Exchange treated exchanged-traded products no differently than other equities. No special treatment for trading in ETFs.

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Meanwhile, NYSE Arca created lead market makers and gave them premium rebates for trading in exchange-traded funds, and gave other market makers rebates as well.

Both models worked fine, as institutional and retail investors pulled out of mutual funds that invested in stocks and rushed in droves into exchange-traded funds that also held baskets of stocks-and could be traded like them, too.

Only about 82 million shares of ETFs were traded in an average day in 2004, accounting for 2.15 percent of consolidated volume. By 2008-at the height of the credit crisis-that had surged to 1.1 billion shares and 12.5 percent of all trading. By 2011, the 1.2 billion shares traded every day in exchange-traded products of all kinds accounted for 15.4 percent of all trading.

Then, the hammer dropped. Daily volume fell 22.0 percent last year, to 941,000 shares a day. And the share of trading went down to 14.3 percent, by Rosenblatt Securities' count.

The bloom was off the boom-even as investors keep pouring money into the funds, adding another $16.6 billion into North American ETFs in the first quarter of 2013, with $1.4 trillion invested all told in ETFs, in the United States.

"Investing in ETFs is continuing to increase. It's just happening in places other than the secondary markets, like NYSE Arca or Nasdaq or BATS," said Laura Morrison, senior vice president for global indices and exchange-traded products at NYSE Euronext.

"It really is critical to us that volumes stay at the levels they are at," or pick back up, she told Traders Magazine.

Now, the exchanges are fighting against and with each other to bring back growth.

Since December, Nasdaq, NYSE and BATS all have stepped up their efforts to grab market share or create more volume in the trading of exchange-traded products-or both. They offer a variety of incentive programs, in particular, to make markets in less-liquid ETFs. Direct Edge says incentives to be a market maker on its exchanges are forthcoming, but its plans aren't finalized.

BATS was first out of the box, with a Competitive Liquidity Program. Its daily rewards required no regulator approval, yet in effect, started paying market makers to create active trading in more ETFs.

"There's a lot of movement in this area. We're talking to all the issuers, we're getting ingrained in the issuer community," said chief operating officer Chris Isaacson of BATS, which now has 18 listed ETFs from BlackRock and ProShares. "Nasdaq and NYSE have looked at what we've done and are trying out different programs" as well-trying to create "holistic experiences" around ETFs, for institutions, traders and market makers.