Nasdaq’s plan to create a special marketplace for exchange-traded funds is drawing mixed reviews. Some see the initiative, which involves grafting the specialist function of the New York and American stock exchanges onto Nasdaq’s multiple dealer platform, as furthering the growth of the booming ETF market.
“This should increase the volume and the quality of the markets,” says Vaidas Uzgiris, head of ETF trading at Timber Hill, the market making division of Interactive Brokers. “We are already a specialist on Arca, and we will be a specialist also at the Nasdaq. It’s a good model.”
To others, though, Nasdaq’s plan to offer price incentives to liquidity providers likely won’t be sufficient to encourage those very providers to participate. “I wouldn’t take the time to commit the capital under [Nasdaq’s proposed] rule base, because I don’t think you can get the rate of return that’s sufficient,” says Daniel McCabe, a former specialist and president of Bear Hunter Structured Products, and currently chief executive officer at M7 Ventures, a company that will soon develop ETFs. “I mean, if you gave somebody a real rule base, where they can make some real money, absolutely.”
Standard Pricing
Nasdaq is signing up designated liquidity providers, or specialists, to those ETFs it already lists, according to Steven Bloom, senior vice president for Nasdaq Financial Products. It expects to add more for its new listings when the market launches this month.
When it opens, Nasdaq hopes its new program will encourage issuers to list ETFs on its market by appearing as a more competitive option to NYSE Arca and the American Stock Exchange. Nasdaq listed 20 ETFs through July, while the NYSE and Amex listed 197 and 337, respectively.
At the program’s heart, a prospective ETF sponsor will select one or more designated liquidity providers to supply seed capital and place two-sided quotes in the Nasdaq Market Center during the new ETF’s initial listing. To give the providers incentive to do this, Nasdaq will make their baseline rate rebate for adding liquidity higher than their charge for removing it during this incubation period, according to William O’Brien, the Nasdaq executive in charge of new listings who moved to Direct Edge ECN after the interview. That is a reverse of standard practice in which take charges exceed liquidity rebates.
When accessing liquidity, the designated market maker would pay 30 cents for every 100 shares executed, according to Nasdaq’s rule change filing. And he would receive a credit of 40 cents for every 100 shares executed when providing liquidity.
Quality Control
Nasdaq will ensure a “backstop of execution quality” within its new market by requiring its chosen market makers to provide liquidity and tight spreads, O’Brien says. “They have to earn the place they’re going to have within our market structure,” he says. The incentive structure only lasts until an ETF is able to trade without support, or once its average daily volume on Nasdaq exceeds 250,000 shares on any two calendar months in a three-month period.
As the thinking goes, Nasdaq can then revert back to standard pricing for the liquidity provider, O’Brien adds. “Once an ETF becomes mature in that type of high-volume environment, the [liquidity provider] won’t need exchange incentives to earn a fair return for providing liquidity.”
Nasdaq has garnered a healthy proportion of ETF trading (see chart), but it still falls well short of NYSE and the Amex for listings. And specialists may have something to do with this fact, as they have played an important role in ETF creation and trading.
ETFs are similar to index-based mutual funds, but trade on exchanges like stocks. And launching one requires initial capital funding that specialists have provided. While Nasdaq currently employs a competing market maker system that doesn’t designate a specialist to make markets for ETFs, both NYSE Arca and the Amex use specialists to be the dealers of last resort and to provide that start-up funding to ETF issuers. In return for making narrow quote spreads, specialists are given a monopoly on the trading.
Fewer Specialists
Using a specialist to trade ETFs in an electronic market isn’t an original concept. The NYSE embraced electronic markets with its hybrid market and the purchase in 2006 of Archipelago Holdings. Its market retains a specialist component within an auction-electronic market fusion. By adding market makers to its electronic model, Nasdaq appears to be arriving at the same point from the opposite direction. It is launching this because its trading platform wasn’t helping ETFs sufficiently in their developing stages. “The historical relationships that have been used to bring ETFs to market didn’t port too well to Nasdaq’s model,” O’Brien says.
That model has worked well with trading ETFs, though, because the most liquid of them are well suited to an electronic market’s advantages in efficiency over floor trading, says Matt Andresen, co-head of Citadel Derivatives Group, one of the biggest dealers of the popular PowerShares QQQ on Nasdaq. But trading ETFs electronically has been both a blessing and a curse for Nasdaq. Because electronic trading has shrunk ETF market makers’ profits considerably, fewer of them have seen enough of an economic incentive to remain in the industry, let alone join sponsors and develop new product to list in this new market.
Nasdaq sees price incentives for designated liquidity providers as a way to capture more ETF listings market share and catch up to the Amex and NYSE (see chart). Nasdaq will not say how many new or existing ETF issuers have signed on to list on the new market. However, Nasdaq’s Bloom says it is aiming to have more than 100 ETFs listed on its market within a short period of time after the launch.
Market makers and ETF sponsors agree that Nasdaq is smart to identify the need for a preferred market maker in its electronic model, as well as to pay that person to provide liquidity. But any incentive to launch an ETF on an electronic market such as Nasdaq’s needs to be substantial to generate any serious commitment from a market maker, McCabe counters, and Nasdaq’s doesn’t appear to be. Still, he adds, “It’s a step in the right direction.”
For their part, ETF sponsors say the new Nasdaq market will be good for shareholders and competition, and furthermore, it could improve overall service. Dan Waldron, senior vice president of ETFs at First Trust Portfolios, in Lisle, Ill., has four ETFs already listed on Nasdaq. As he weighs the prospects of launching new ETFs there, Waldron says he’s intrigued by the prospect of a specialist-type broker entering the equation. “We’re confident it’s going to be a good change.”
But sponsors have also seen electronic trading decrease the number of market makers, forcing issuers to look elsewhere to find sources of seed capital, according to Nicholas Gerber, portfolio manager at Ameristock/Ryan Treasury ETFs. He says sponsors will look anywhere if they have a good idea, from primary market makers to hedge funds. “Or, maybe they’ll come up with the money themselves for the first create, and therefore, they can go around the specialist system by going and using the Nasdaq,” Gerber says.
But he adds a sober note to the effect Nasdaq’s new ETF market could have on the trend of the declining number of market makers: “It may accelerate it, if all of a sudden we find out there are other sources of potential seed capital and market makers.”
