The business of listing new exchange-traded funds is in the doldrums and so are Nasdaq’s plans to build a competing ETF marketplace.
The exchange said last September that when it launched its new service in a month it would be shooting for 100 listings very soon thereafter. So far, it has added just nine to its initial 20. As part of its plan to lure infant ETFs, Nasdaq this spring sweetened the terms of its rebate policy for ETF market makers. Nasdaq recently began paying “designated liquidity providers,” those market makers who seed and
support new ETFs, 40 cents per 100 shares for quoting the ETFs. Market makers get that rebate until the security’s average daily volume reaches 10 million shares per day. After the security reaches that level, the rebate reverts to Nasdaq’s standard tiered payout of between 20 and 25 cents.
Market makers, or specialists, are crucial to the launch of a new ETF because they “seed” the new security with their own funds.
Previously, Nasdaq paid the dealers 40 cents per 100 shares only until the ETF traded an average of 250,000 shares per day. After that, the rebate dropped to the standard pricing.
The latest move, which is being described as overdue, puts Nasdaq’s ETF pricing on a par with that of the New York Stock Exchange’s Arca platform.
Arca pays its lead market makers 40 cents per posted 100 shares.
The American Stock Exchange, the largest ETF-listing venue, has paid its specialist 24 cents per posted 100 shares since last July.
“It’s been harder for Nasdaq to attract liquidity providers because of that ceiling,” says Matt Hougan, editor of IndexUniverse.com, which provides independent ETF and index funds analysis. “I did hear a lot of push-back from specialist firms.”
For its part, the Amex is the largest ETF-listing venue, with 401 securities, according to Morningstar. NYSE Arca lists 248. Very few ETFs trade on the Amex, however. Most of the volume is done on Arca and Nasdaq.
By raising the ADV ceiling to 10 million shares, Nasdaq is essentially matching the policies of Arca and Amex, which impose no ceilings. The vast majority of the Amex’s ETFs, for example, trade no more than 500,000 shares per day, according to data provided by Amex.
Nasdaq’s Aims
Unlike its competitors in the ETF listings game, which have always employed a single specialist, or lead market maker, to seed a new ETF, Nasdaq is sticking with its multiple-market-maker platform.
When it launched its ETF marketplace last year, Nasdaq made it clear it would encourage more than one dealer to seed a single ETF.
Given the current slump in new listings-only 42 in the first four months of this year, compared with 259 last year-Nasdaq is convinced that a multi-dealer model is the future.
“That’s why we raised the tiers: to have better economics to try to entice multiple people to designate seed capital,” says John Jacobs, Nasdaq’s executive vice president of financial products and marketing. “The number one issue I think [ETFs are] facing is seed capital. That’s our mechanism to do that.”
The days of the single specialist seeding capital for ETFs are over, Nasdaq’s Jacobs adds. “We don’t think that’s the answer anymore,” he says. “The economics have changed, and that’s no longer going to happen.”
Currently, there is just one designated liquidity provider for each of the 28 Nasdaq-listed ETFs that have them. The new payout affects 28 of Nasdaq’s 29 listed ETFs. Only the ultra-liquid Qs-PowerShares QQQ Trust-trades over the 10-million-shares ADV threshold.
The market makers who have signed up to be “designated liquidity providers” with Nasdaq so far include Timber Hill, Goldman Sachs Execution Services, Susquehanna Investment Group and Sun Trading.
On the NYSE and Amex, LaBranche & Co., Goldman, Kellogg Capital and Susquehanna are the big players.
What’s in It for Specialists?
Nasdaq’s rule change comes at a time when profits for those market makers who seed capital for new ETFs continue to decline dramatically.
Formerly, specialist firms would provide seed capital for ETFs in return for prime exposure to the order book. With a good idea behind the ETF, as well as the right placement and proper demand for it, the market maker could use his advantageous position regarding order flow to earn back that seed capital quickly en route to profits.
As the markets for trading ETFs have increasingly gone electronic and spreads have narrowed, lead market makers’ advantages and profits have shrunk. Thus, there is less incentive for specialists to fund ETFs that likely will produce few opportunities for them in return.
But ETF industry insiders are mixed about what Nasdaq’s move will achieve for specialists.
According to a market maker in the industry who does not want to give his name, Nasdaq’s move is a step in the right direction, but will likely achieve little to encourage dealers. There is a need, he says, for new thinking on how to fund ETFs that should not necessarily be dependent entirely on specialists.
But a higher liquidity rebate makes a difference for Vaidas Uzgiris, head of ETF trading at Greenwich, Conn.-based Timber Hill, the proprietary division of Interactive Brokers. Without addressing Nasdaq’s move specifically, he says a high rebate is a strong incentive for specialists at the firm.
“Making the specialist position more desirable means more people would be willing to provide money for [new ETF] seedings,” Uzgiris says.
Wanted: Better Ideas
But higher rebates aren’t the primary issue, according to Lisa Dallmer, senior vice president, ETFs and indexes, at NYSE Euronext. The problem lies in the low demand for certain kinds of ETFs.
When seeding an ETF, specialists have both fixed and “carry” costs, she says. And if the specialist wants to use trading revenue to offset those costs, he must have an expectation of specific ADV trading revenue. This becomes a problem if too many new ETFs are fourth-to-market products, or worse, they lack sufficient demand, Dallmer says.
“We can’t expect transaction fees to completely be an offsetting revenue source against seed capital in its entirety,” she says. “You need that demand, that pull, from the distribution channel, from the retail marketplace. And if that is latent, or if that requires some build, then that means that whoever seeded the fund has some carrying costs for a while.”
To others, such as IndexUniverse.com’s Hougan, Nasdaq’s rule change will increase its profile across the industry, as well as give it an opportunity to play a bigger role in the space for listings. This is important as Nasdaq prepares to battle a potential ETF juggernaut for market share, should the proposed NYSE-Amex merger be consummated.
“All the ETF providers want at least two choices in listing venues,” Hougan says. “Nasdaq is getting its act together to really make a bid to be a legitimate alternative to a possible NYSE-Amex goliath, and this is a major piece in that; it will play a big role in keeping liquidity providers interested.”
SIDEBAR: Quieting the Boom
The pace of new ETF listings has begun to slow. Through April, only 42 ETFs have been launched, Morningstar reported. This compares to 259 ETFs through the same period in 2007. In addition, there were 451 ETFs in registration with the SEC by the end of 2007, and there were 429 year-to-date through April 24, according to IndexUniverse.com.
The slowdown comes on the heels of tremendous growth in ETF listings.
Through the first quarter this year, ETFs’ total assets under management were $581.8billion, according to figures from the fund research firm, Morningstar. Over the same period in 2007, the total was $454.1 billion, and in 2004, the total was just $228.3 billion.
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