Following a similar proposal by Nasdaq OMX, NYSE Euronext has unveiled a plan to allow market makers to get paid for providing liquidity for exchange-traded funds. If approved, the plan could reduce the number of funds listed without lead market makers.
On April 27, NYSE formally asked the Securities and Exchange Commission to authorize a pilot program that would add incentives for firms that become LMMs. Under the proposal, issuers would be allowed to pay an additional $10,000 to $40,000 per year to attract market makers.
Bryan Johanson, managing director for global index and exchange-traded products at NYSE Euronext, said firms have been increasingly reluctant about becoming LMMs, and the exchange wanted to offer an additional incentive to attract market makers to that role.
Until 2007, all exchange-traded products listed on the NYSE Arca exchange had LMMs, which receive higher rebates from the exchange and pay lower fees in return for market-making obligations. In 2007, five of the 223 new funds that listed on Arca did not have LMMs. Last year, 297 new funds listed on Arca, and 26 of them did not have LMMs.
The lack of LMMs can cause serious problems for funds that are lightly traded. Even though an ETF is by its nature as liquid as its underlying securities—since shares can always be created or redeemed using the underlying stocks—a fund with a low volume and a wide posted spread will tend to be shunned by investors.
Under the NYSE plan, issuers could pay an optional quarterly incentive fee to the exchange, which would then use that money to distribute credits to LMMs that meet minimum performance standards.
Johanson said the exchange discussed the matter with market makers and found that around $10,000 to $40,000 was the level at which they started to consider taking on new exchange-traded products.
“We didn’t want this to be overly burdensome for the issuers,” Johanson said. “We tried to balance their interests with the market makers so we could come up with a figure that was appropriate and fair.”
A Financial Industry Regulatory Authority rule prohibits payments for market making, but NYSE argues this rule applies to securities of individual companies, not to exchange-traded products.
According to Johanson, ETFs probably weren’t even around when the first version of the rule was created. In spirit, the rule is aimed at preventing price manipulation, but that shouldn’t be a problem with ETFs, which are transparent and can easily be arbitraged against their underlying assets, he said.
Damon Walvoord, director of index and ETF sales and trading at Susquehanna International, which acts as an LMM, said he is supportive of the proposal, though he noted the modest incentives were not likely to lead to a sea change in the industry.
“It’s been a very limited number—us and only a handful of others—that have been actively taking on new products in the existing program,” Walvoord said. “Anything incrementally better helps the equation when a new listing comes along.”
Walvoord said that from his perspective, the risks and costs involved in being a lead market maker far exceed $40,000 a year, but if the program is embraced, it could bring millions of dollars collectively into the LMM industry. That could tip the scales and get some firms already active in ETF market making to jump the broom and become official LMMs.
Last month, Nasdaq proposed issuers on its exchange could pay $50,000 to $100,000 annually to fund payments to market makers. BATS, which launched its first primary listing of an ETF earlier this year, already has its own plan in place to encourage market making of exchange traded products.
In Walvoord’s view, all of these programs have their merits, and they will likely appeal to different firms in different ways, depending on how they are structured. The important thing, however, is that people are taking an interest in encouraging LMMs and improving market making.
“The exchanges and the marketplace at large are paying attention to this issue,” Walvoord said. “I think what’s game-changing is the fact that they’re taking first steps in this direction.”
Noah Hamman, founder and chief executive officer of the ETF issuer AdvisorShares, said he is in favor of any plan that will help tighten spreads. He is excited about the proposals, though he added he was not sure how effective they will be.
Increasing incentives for market makers could be particularly helpful for actively managed ETFs like the ones offered by AdvisorShares. These funds tend to have lower trading volumes in comparison to index-based products, so better market making could increase displayed liquidity and make investors more comfortable with the funds.
“Our type of ETF isn’t about the buying and selling and frequent use,” Hamman said. “I’m getting guys who are dollar-cost averaging. They’re buying it like they would buy an actively managed mutual fund, so that volume isn’t always there.”
If market makers could be enticed to step in and lower overall costs for investors, AdvisorShares would most certainly participate in the program, Hamman said.
