Lead ETF Market Makers Face Hurdles

With the rise of exchange-traded funds, more attention is being focused on those who make markets for ETFs. Though one might expect the business to be booming, it has remained a difficult space for those involved.

ETFs that trade on NYSE Arca use lead market makers (LMMs) to maintain continuous, two-sided orders. But as ETFs have gotten more complicated, many LMMs have tended to specialize, and there seems little interest among new firms to get into the business.

Goldman Sachs and Knight Capital are the two largest LMMs, but they are joined by Susquehanna, IMC Chicago, Getco and a number of smaller firms.

Regulatory changes instituted over the last few years have changed the shape of the LMM business, according to Reggie Browne, managing director of the ETF team at Knight Capital. He said most firms are not running to become LMMs.

“You still need a lead market maker to ensure fair prices, and to be accountable for an ETF having a two-sided market,” Browne said. “But I think it will be a small number of people involved in that space. I don’t see it growing tremendously.”

Some of the smaller LMMs mostly trade ETFs based on U.S. cash equities, as they tend to be easier to quickly arbitrage. Browne said when it comes to ETFs based on commodities, fixed income or foreign holdings, or to ETFs that are actively managed, few smaller players want to get involved.

“There are a lot of regulatory burdens surrounding LMMs, and if it’s not a part of a larger initiative, I don’t see that there are a lot of great benefits to being a lead market maker,” Browne said. “It’s almost a break-even business.”

Each LMM brings a different skill set to the market, according to Laura Morrison, head of U.S. exchange traded products for NYSE Euronext. She notes that not every LMM is interested in trading every product, and some have proven to be quite selective in what they trade, she said.