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.
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.
The Nasdaq Stock Market in late March got approval from the Securities and Exchange Commission to start a Market Quality Program that breaks a long-standing ban against issuers paying for market making in their shares. NYSE Arca is following suit with its own ETP Incentive Program.
Now, today, Nasdaq OMX is relaunching its PSX exchange as an ETF-focused exchange, in direct competition with NYSE Arca, which has been the market leader.
Nasdaq also plans to introduce thousands of indexes on which ETFs can be built, as well ETF-specific order types. First up: an order type tied to the actual value of the holdings in a fund, recalculated every 15 seconds, now under extended review by the SEC.
Why so many initiatives, all of a seeming sudden, by the pioneer of electronic trading?
“It just reeks of market share concern. Because they have lost market share,” said Richard Repetto, principal for equity research at Sandler O’Neill & Partners.
Five years ago, Nasdaq handled 39.7 percent of all share volume in ETFs, by its own statistical count. By March of last year, that had fallen to 24.7 percent. By this March, Nasdaq’s share had plummeted further, to 18.1 percent.
A big factor: the move of institutional trading off exchanges and into dark pools, brokers’ own pools of orders and alternative trading systems.
In the first quarter of 2013, off-exchange trading reached 36.2 percent of all consolidated volume, a high; and a third of all ETF trading as well. Nasdaq chief Robert Greifeld, NYSE chief Duncan Niederauer and BATS chief Joe Ratterman all went to the nation’s capital in early April to discuss how to bring volume back to public exchanges with SEC Commissioner Dan Gallagher, a former deputy director of its Division of Trading and Markets.
But also factoring in: the rise of BATS and Direct Edge, which have taken over about a quarter of all trading in ETFs.
Nasdaq acknowledges it is making its moves in a concerted attempt to regain share in ETF trading volume. But all the major exchange operators are getting in the game. Particularly since overall volume in equities and ETFs is down a third, to 6.6 billion shares a day, since 2009.
“These guys are fighting for every basis point of market share they can get,” said Repetto. “You can see where they are going to focus on ETFs.”
The aim of all this competition: to gain the favor of buyside traders and retail investors by creating conditions that narrow the spreads between bids and offers, improve the discovery of true underlying prices of ETF shares and create liquidity in more than the top 200 funds.
In so doing, they hope to make ETFs an even bigger part of institutional trading and market activity.
“That’s pretty much the answer. That’s the nut of it,” said Chris Hempstead, director of exchange-traded fund execution at institutional-only agency broker WallachBeth Capital in New York. “If all this has legs and it sticks, then you have a new version of the market going forward.”
The key to getting ETF trading back on track as a growth engine for the exchanges: improving the liquidity of less-liquid funds.
Only the top ETFs, such as State Street Global Advisors’ SPDR S&P 500 (SPY) and SPDR Gold Shares (GLD) funds, Invesco’s PowerShares QQQ fund and top funds from major sponsors such as BlackRock and Vanguard Group get broadly traded. Roughly 1,200 out of the 1,400 ETFs extant in U.S. markets are thinly traded.
See Chart: ETF Interest
In fact, more than 50 percent of ETFs trade fewer than 25,000 shares a day, according to Damon Walvoord, head of ETF Capital Markets for Susquehanna Financial Group, which makes markets in the funds.
To date, he says, the compensation offered by the Nasdaq Stock Market and NYSE Arca to make markets in ETFs has been “incremental,” not substantial.
A lead market maker might get 10 cents per 100 shares traded in an ETF. And the lead market maker might handle 50 percent of the trading in a given fund. That works out to about $12 a day, on 12,000 shares handled. Or $3,000 a year.
“As you can imagine, not too many people are clamoring to get into that business,” which consequently impacts liquidity, Walvoord said.
Market makers are expected to provide expertise, infrastructure, systems and capital to serve as a dedicated liquidity provider for new issues.
“We’re taking a financial risk, sucking up capital in order to launch these things,” said Reggie Browne, managing director of ETF market making at Knight Capital Group. Knight makes markets in 440 funds on NYSE Arca, the leading ETF exchange, and 550 overall.
See Chart: ETF Market Making Incentives
Market makers and seeding “partners” typically grant a new ETF $2.5 to $ 5 million to get its trust started. That can be $30 million to $40 million, he says, “if it is something that needs a lot of capital to launch, like senior loans, for example.”
State Street Global Advisors in April launched an exchange-traded fund based on secured debt of U.S. and non-U.S. companies in conjunction with the Blackstone Group, one of the world’s largest alternative asset managers. That capital-intensive fund is the first to provide exposure to senior loans. Knight is the lead market maker, and Browne pegged the cost at $61 million, to the parties involved.
But the area that needs propping up, market makers say, is the “long tail” of the ETF market. The less-liquid funds. Browne estimates that 5 percent of listed ETFs have so little activity they don’t even have lead market makers.
This is where the exchanges have now come in, to try and change the dynamics of the market.
The Nasdaq Stock Market has won approval from the SEC to pilot a Market Quality Program, that attempts to induce market making in ETFs that trade fewer than 1 million shares a day.
NYSE Arca has followed suit, filing and refiling a plan it now calls the ETP Incentive Program, to also incent market makers to support trading in less-liquid funds.
The Nasdaq and NYSE plans require SEC approval because they are going at the heart of a Financial Industry Regulatory Authority rule that prohibits paying firms to make markets in securities.
FINRA Rule 5250 prohibits any payments by an issuer or fund promoter to get quotes published or to get an exchange member to act as a market maker.
“We are going right at FINRA’s Rule 5250,” said David LaValle, vice president and head of ETP Listings at Nasdaq OMX. “We’re going right to the heart of the issue.”
In Nasdaq’s tack, an ETF sponsor pays either $50,000 or up to $100,000 in addition to regular listing fees and chooses which funds will be in its Market Quality Program.
Each quarter, the exchange makes payments from those “MQP” fees to market makers that meet specified liquidity and market quality goals.
These include trading inside the national best bid or best offer for 25 percent of the trading day for 500 shares of a fund; posting a bid that is no less than 2 percent away from the national best bid and an offer that is no greater than 2 percent away from the national best offer 90 percent of the day; and displaying liquidity on each of the bid and offer sides of trading of 2,500 shares each way, through the day.
“We wanted to answer what I’ve been calling the chicken-and-egg dichotomy that exists between the issuers and the market makers,” LaValle said.
Issuers, according to LaValle, say: “We need greater liquidity at the inside, so that when we go to sell these products, we can attract assets to our funds.”
The market makers would say: “We will provide greater liquidity at the inside when the product begins to trade.”
Issuers’ response would be: “The product’s not going be in trading until we have greater liquidity at the inside.”
“So we’re trying to tackle that question head-on,” LaValle said. “And we feel like it was something that the industry was calling for.”
The competition for the payouts should lead to narrower spreads, Knight’s Browne maintains, and incent more companies to become market makers. “It’s part of the exchange’s job to find people to do it,” he said.
See Chart: Made to Order
FINRA’s stated fear has been that paying for market making could lead to manipulation of shares and other fraudulent practices.
FINRA “has this fear that some evil issuer will get in cahoots with some awful manipulator and pay some manipulator to manipulate their stock,” said James J. Angel, capital markets professor at Georgetown University.
But the “issuer is not grabbing Tony Sopranos off the street and engaging in a grand conspiracy here.”
FINRA declined comment.
“It’s a natural evolution born from the end of the specialist market-making system, where people via rule had an affirmative obligation to lay a tight market and maintain a fair and orderly market and basically provide liquidity when no natural liquidity was available,” said Dave Herron, chief executive of the Chicago Stock Exchange.
In Angel and Herron’s estimation, you need incentives such as these payments to kick-start trading in less-liquid securities.
In fact, Angel believes issuers of straight stock also should be allowed to pay for markets to be made in their shares, particularly in an era of razor-thin commissions and fees in nearly all-electronic markets, at this point. Penny spreads, Herron notes, are what made the specialist business unprofitable-and cease to operate.
“Liquidity begets liquidity,” Angel said. “When someone makes a market in a stock, they make it more attractive for other people to trade in a stock.”
And the cost can be insignificant. “I think it (the market quality program) should be permissible for as long as you want to do it, because once you get to let’s say a $5 billion dollar fund, the very small amount that is involved in this incentive, is trivial,” said Gary Gastineau, principal at ETF Consultants in Short Hills, N.J. “It might be a fraction of a penny a share.”
NYSE Arca has filed a rule-making proposal for a similar pilot, which it calls its ETP Incentive Program. In its approach, issuers would pay an “optional incentive fee” of between $10,000 and $40,000 a year into its general revenue fund. The exchange would take a slice as an administrative and then pay out the rest to a lead market maker that would have to meet similar performance thresholds.
While Nasdaq will collect the fees from the sponsors, all fees will be paid out to market makers. None will be retained by the exchange in its program, according to LaValle.
The first out of the box, though, was BATS, with its Competitive Liquidity Provider program.
That program did not take on Rule 5250. Instead, it took funds straight from listing fees to incent market makers to provide a continuing stream of quotes on exchange-traded products that are “inside” the best bid or offer on any venue where shares are traded.
The market maker who provides the best flow of quotes-in price and size-to buy or sell shares in a given security in a given day will get 80 percent of a payout of $200 a day, roughly, as BATS’s Isaacson describes it. The second-place “winner” gets the other 20 percent. Finish atop the leaderboard consistently over time and over multiple ETFs, and you’re talking real money.
This sort of competition should be music to buyside firms’ ears, increasing the amount paid for sell orders and lowering the cost of buy orders. “Time will tell, and the proof will be in the markets. We are going to closely monitor each exchange and see what the impact is on spreads,” said Timothy Coyne, global head of ETF Capital Markets at State Street Global Advisors, which manages more than $340 billion in ETF assets worldwide in its line of SPDR products.
In March, BATS also started publishing what it called “market quality” statistics, drawn from standardized data on the consolidated tape of stock and exchange-traded fund transactions. The point: to show which exchange is in fact lowering the spreads.
The highest rankings go to the exchange that gets the best prices for both sellers and buyers. In effect, “execution quality” equates to generating the narrowest spreads between offers and bids. For 60 out of the top 100 exchange-traded products, for instance, BATS Global Markets’ primary exchange, the Z exchange, achieved the narrowest spreads on April 2. But NYSE’s Morrison notes that Arca maintains quotes at the national best bid and offer 91.3 percent of the time, compared to BATS’ 90.0 percent, by statistics it keeps.
All of this intensity to track and improve the quality of execution is expected to narrow spreads and help foment trading in more ETFs.
But the incentives should not be necessary, said one senior equities trader at a Chicago asset management firm. “Isn’t this what market makers are supposed to do anyway?” he asked.
The bottom line drives all players, though. By one estimate, a lead market maker in a “market quality” program like Nasdaq’s might make $30,000 per fund per year.
That’s better, but not on the par with venues in Europe where contracts for market making are legal and denominated in the millions of dollars for a suite of ETFs.
“It’s better by a factor of 10, but I’d still argue that it is not commensurate with the cost and risk of the task at hand,” Walvoord said.
The intensifying competition for ETF order flow is also leading to new forms of discovering prices for shares of funds.
A prime example is an order type for which the Nasdaq Stock Market is seeking approval from the SEC.
This order type (See “Made to Order,” p. 23) tries to refine pricing for the ETFs it handles, by allowing traders to peg their orders to the net asset value during the day of holdings in a given fund. The “intraday NAV” gets recalculated every 15 seconds.
This gives a trader the chance to limit orders to the actual value of assets, when market trading diverges from the underlying value.
“If immediacy of execution is something that you’re interested in, this is probably not a product for you,” said LaValle. “But this is a product that is going to give greater certainty on the quality of executions.”
With this set of automated instructions, the price that the user is willing to execute at changes four times a minute, based on the calculation of the actual value of the stocks in the fund.
At most times, that intraday value will be inside the normal bid-and-ask spread, LaValle notes. But there will be times when, for instance, a fund is quoted at a premium to the actual value of the fund. If a trader used a conventional limit order, the trade might execute at $25.50 in that case. With the 15-second calculations, you might not pay more than $25.00, if you peg the order to the fund’s actual value.
“This will offer protection to any investor who wants it,” said LaValle.
Nasdaq expects to file rule-making proposals for two or three additional ETF-oriented order types by year’s end.
Then there is Nasdaq OMX’s other big play to capture more volume of trading in ETFs: the relaunch of PSX.
PSX, which picked up less than 1 percent of all trading volume in its last incarnation, had given priority to the size of an order over the speed of placing one. Now, speed to a trade-matching engine will take priority over the size of an order, just like all other national stock exchanges.
The new version of PSX features an aggressive form of “maker-taker” pricing, aimed at finding, creating and rewarding lead market makers in all ETFs, whether listed on NYSE Arca, the Nasdaq Stock Market or the BATS Exchange. Lead market makers get a “premium” rebate on each share traded in a particular fund; and all other market makers are eligible for an above-average rebate and a chance to take over the lead.
The other public venues in trading ETFs are hardly standing still. The Nasdaq Stock Market, NYSE Arca and BATS all have taken their own approach to creating programs that reward intermediaries for making markets in less-liquid funds.
“That one might come closer to being a structure that matters,” said one market maker, because of the premium rebates that are expected to be offered.
PSX wants to become a “world-class ETP exchange,” in LaValle’s words. That would put it up against NYSE Arca, which has established itself as the primary ETF-focused exchange in North America.
Of the 1,442 exchange-traded products listed on U.S. exchanges, 1,328 are listed on NYSE Arca. Nasdaq is next, at 96, and BATS is at 18.
NYSE Arca also handles the most ETF trading, accounting for about 21 percent of share volume and 22 percent of dollar volume. Nasdaq is next at about 15 percent, and BATS is nipping at Nasdaq’s heels.
NYSE Arca has built its lead in listings with a “consultative approach with all issuers” of funds, making the launch of a new fund almost a turnkey process, according to Morrison.
The exchange will help them find everything from an index creator to a custodian to a transfer agent, in order to get started. If it doesn’t have an index in its quiver, then it will create one.
PSX has no plans to be a listing venue, however. Instead, it’s trying to get a lead market maker in place for trading in shares of every ETP listed at Nasdaq, NYSE Arca or BATS.
“For the first time, for example, there will be a lead market-making opportunity for QQQ, and, for that matter, SPY,” said Michael Blaugrund, vice president of equities strategy at Nasdaq OMX.
But getting the opportunity doesn’t mean a market maker will stay in the lead position permanently. The exchange, on day one, plans to introduce a lead market maker program that is based on competition to earn a rebate that is “more aggressive than (in) competitors’ lead market-making programs,”
Blaugrund said. And any other market maker at any time can challenge the leader and try to take over that rebate.
Here’s how the competition will work. PSX will put baskets of ETFs up for bid by registered market makers. The participating market makers each will commit to an amount of time and size of order that it will maintain at prices inside the national best bid and offer that is greater than the exchange’s minimum requirements.
The winning bidder becomes the lead market maker and is committed to maintain that level for the first six months of the program. And during that time, any other market maker can get rebates that are a notch back of what the lead firm gets.
Those market makers, if they think they can do a better job at tightening the spread or putting up larger orders inside the best bid and offer, can also notify the exchange if they want to take on the incumbent lead market maker, Blaugrund said. Over a two-month challenge period, if the rival creates a better market for shares of a fund, then that firm becomes the lead market maker.
“It keeps the incumbent lead market maker on its toes. It can’t just rest at the program minimums,” said Blaugrund.
PSX will also have a second market-making program, called XLP, which allows a firm, regardless of the amount of volume it does, to achieve a premium rebate level. A firm will get this by quoting 25 percent of market hours or more inside the best bid or offer, in a given security. The idea is to make the exchange attractive to a wider range of market makers.
The question awaiting the launch is just how attractive Nasdaq OMX plans to make the rebates to market makers for “making” liquidity in ETF shares and how low it intends to keep the fees paid to market participants who “take” liquidity away. And whether institutions will resist “maker-taker” pricing, which benefits high-speed traders working in small slices of shares, as they have in equities.
If the rebates exceed the fees, the pricing will be “inverted”-meaning Nasdaq PSX will actually be subsidizing the making of markets.
This is not without precedent. At Nasdaq. This year.
On March 1, Nasdaq introduced a new rebate program for Designated Retail Orders in stocks. The rebate to qualified market makers was 35 cents per 100 shares and was only offset by a take rate of 29 cents a share. Sandler O’Neill’s Repetto estimates that that lowered Nasdaq’s revenue per transaction by 17.5 percent during the first quarter, costing the company about 3 cents of earnings a share.
In its pursuit of ETF business, Nasdaq intends to meet or beat NYSE Arca in creating relationships with issuers.
With a listing market (Nasdaq Stock Market) and an ETF-focused exchange (PSX) that is “agnostic” about where funds are listed, an issuer can come to Nasdaq with or without an idea for a product, LaValle notes. Nasdaq will help define an idea for them, build, test and monitor an index on that idea, launch options on that index, build an exchange traded product, launch options on that exchange traded product, list the exchange traded product, trade the exchange-traded product, build liquidity around it, and deliver data services on that product, as well.
As part of the buildout, Nasdaq also aims to become a global provider of constantly recalculated indices, using its INET technology.
By the end of the year, it plans to launch and maintain 150,000 indices, in competition with major index providers such as Standard & Poor’s, Russell Investments and MSCI. And it is prepared to create custom indices for ETF issuers, along the way.
“It’s one of many critical components to building a very successful and full service offering in the ETP space,” LaValle said.
NYSE Euronext, which has created about 300 indices, says it plans to cover that bet. “We’re going to work on that next year,” Morrison said.
That remains to be seen. But, if all the attention to ETFs works out right, “the buyside is going to have the benefit of better pricing. They’re going to enjoy better displayed markets, better price discovery,” said Blaugrund. “And if they’re looking to move in or out of a position, they will be able to do that with less liquidity risk.”
Whether at Nasdaq, NYSE or BATS.
“Ideally, it is a big deal,” said Hempstead. “Now all of a sudden, if you can grow the list of ETFs from 200 to 400 that are easy to trade algorithmically with tight spreads and tight screens, then I think that is a win for The Street.”