A EUROPEAN JOURNEY THROUGH EXCHANGE TRADED FUNDS.

By Umberto Luca Restione, Banca IMI, Market Hub, Brokerage & Execution

Exchange traded funds (ETFs) have witnessed significant growth since their inception in the early 1990s, both in scale and industry development. Assets under management have continued to increase at a healthy annualised pace of 19% over the last ten years, reflecting investors interest in passive, liquid products.

MiFID II has been a game-changer

The US ETF market is the biggest and most established market with $3.4 trillion in total under management, which at the end of 2017 represented a hefty 72% chunk of the entire market. Although European ETF assets are only a quarter of those in the US, the region is the second largest ETF market and has massive growth potential. Regulation, most notably MiFID II, has helped boost ETF distribution especially in the retail sector. Greater transparency has generated interest among wealth managers and financial advisors to employ these low-cost products.

For example, regulatory initiatives including pre- and post-trading rules, have improved visibility into European ETF trading activity and market depth, highlighting the direction of flows. In the first year after MiFID II came into force, registered market-makers in Europe increased by 25%, a tailwind for the trading environment in terms of liquidity and spread skew.

However, challenges remain and Europe still has a long way to go before it catches up to the US. For one thing, European ETFs are listed on multiple exchanges, often in more than one currency resulting in market inefficiencies, in particular liquidity fragmentation and price opacity. Moreover, the lack of a European centralised settlement depository is problematic in terms of redemption because it means that ETF distributors have to relocate inventories from different repositories. This is a costly and time-consuming process.

Bond markets favour ETFs

Even if equity ETFs remain the main focus on both sides of the Atlantic, it is bond ETFs which are gaining the most traction, growing three times faster than their equity counterparts. Investors who seek exposure in debt markets have turned to fixed income to access emerging market (EM), high-yield and corporate bonds for better risk‑adjusted returns in a low interest rate environment.

Money is also increasingly moving into bond ETFs as liquidity in the OTC fixed income markets is evaporating. Debt-linked ETFs facilitate investment in securities that would be expensive to access individually. In addition, investors are attracted by the breadth of offerings for core and tactical asset allocation, as well as the potential to use them for hedging purposes. This is because they target duration and exposure compared to government bond futures and credit default swaps.

Changing market dynamics

The European ETFs trading landscape is no longer the exclusive domain of top-tier investment banks, with market-making now also controlled by non-banks and proprietary high frequency trading firms who can maintain profitability through a cost-efficient structure. As a result, bank margins of on-exchange ETF trading have suffered in recent years and they continue to be under pressure.

As to the buyside, recent studies have highlighted that the most important criterion in choosing a counterparty is price competitiveness. As a result, investment banks are faced with increased competition and need to improve their technological prowess to retain and attract clients. This means being able to cross ETFs internally and develop competitive solutions which automate fast pricing and hedging, both on-exchange and synthetically.

Moreover, banks must be able to connect to a wide range of regulated markets, MTFs and brokerage venues to satisfy clients’ liquidity needs and process data for an effective pricing model.

Financial platform providers and exchanges are also changing their offering to meet the demand for ETFs. For example, Tradebook, with its ETF Request for Quote platform, allows institutional investors to find blocks by aggregating liquidity from multiple providers anonymously and to dynamically find the best execution through smart order routers. Euronext is developing a similar infrastructure while Borsa Italiana tailored the RFQ functionality on the listed market ETF Plus, and it is now gaining traction among medium-sized investors.

With ETF white label platforms becoming more popular in Europe, in an attempt to overcome market entry-barriers and leverage economic scale opportunities, the scene is set for continued expansion of ETF trading across all asset classes.

©Best Execution 2019
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