Cash lure to stop firms deserting ETFs in times of stress

August 8, 2013 2:39 pm

Cash lure to stop firms deserting ETFs in times of stress

By Arash Massoudi and Tracy Alloway in New York

On Wall Street, it seems money talks. Three years after the “flash crash” that sent prices of exchange traded funds reeling, US stock exchanges say they have worked out a way to motivate the financial firms that are supposed to ensure smooth trading in ETFs: pay them more.

Two of the biggest venues for trading US ETFs are readying pilot programmes that they hope will encourage better behaviour from the top “market-makers” of the funds – financial firms such as Goldman Sachs and KCG.These lead market-makers are supposed to quote bid and offer prices for ETF shares even in times of market stress. But on May 6, 2010 – the day of the flash crash – they were nowhere to be found. A report by US regulators later said the funds were affected by the day’s abrupt events much more than traditional equities.

Investors of all different stripes have flocked to ETFs, which typically track indices and trade on exchanges like stocks, as a way of gaining quick and easy access to assets that might otherwise have only been available to sophisticated investors. But as the sector has expanded, some critics are asking whether the fundssuffer from structural vulnerabilities that flare up in moments of market stress, such as the flash crash.

“Machines [used by market-makers] are programmed to pull away when things are not perfect,” says Eric Hunsader, founder of trade research firm Nanex. “The degree of disruption during the flash crash affected more market-making systems than normal but events like that happen daily – just to a less severe level.”

Critics say ETFs may be more susceptible to bouts of volatility because they rely on a wide cast of market-making characters to sustain them and make sure they accurately track their underlying securities. In addition to the lead market-makers charged with ensuring smooth trading of an ETF’s stock, the funds also have “authorised participants” that help to create ETF shares and make sure they match the basket of securities the fund is meant to be replicating.

APs make their money from arbitraging small differences between an ETF’s underlying securities and the share price of the fund itself. Lead market-makers, however, are paid according to how many shares of the ETF change hands.

“If they don’t trade a lot, the lead market maker doesn’t get paid a whole lot,” says Laura Morrison, who heads US exchange traded products listing and trading at theNew York Stock Exchange. Under the NYSE’s pilot programme, ETF issuers will be able to pay financial firms a set retainer to act as lead market-makers for their many funds.

The programme highlights an interesting development in the ETF market. While the number of exchange traded products in existence has jumped from 105 at the turn of the century to almost 5,000 now, the funds are closing in record numbers as many of the new offerings fail to attract enough investors – and market-makers – to keep going.

“It’s up to the issuer to secure that lead market-maker, and lead market-makers have become more and more selective of the products they’re willing to sign up for,” says Ms Morrison. “A lot of that has to do with the fact that there are just so many more products out there.”

The NYSE’s incentive programme, expected to start in the coming months, will allow ETF issuers to pay lead market-makers $10,000 to $40,000 per ETF per year, regardless of how much the fund is traded. At Nasdaq, ETF issuers are looking to offer $50,000-$100,00 to top market-makers in a product if certain quoting requirements are met.

The programme “gives the LMM the confidence they will receive this dollar amount as long as they meet their obligations”, says Ms Morrison. The NYSE is also hoping the pilot effort will encourage new firms to sign on to make markets in ETF shares.

Companies that run ETFs, such as BlackRock, have said that despite the additional money they may have to shell out, they welcome the exchanges’ experiments to encourage market-makers to stay committed to the funds. Three years on from the flash crash, the NYSE says only rarely does it flag lead market-makers for bad behaviour, despite the general impulse for them to pull back from ETFs in difficult moments.

“The ability of the exchanges to offer proper incentives to market-makers who support new or less frequently traded ETPs … benefits all investors,” BlackRock executives said in a comment letter sent to US regulators last year.