The Finance Hive: Digital Café, 14th December
Last month, our senior Equities members came together on Zoom to discuss benchmarking ETFs—from measuring trade performance and the best available benchmarks to market structure, fragmentation and potential solution providers. Some members are yet to fully embark on their ETF journey, whereas others specialise almost entirely in this area. Throughout this blog, we’ll take a closer look at the applications for ETFs, along with some of the common challenges our members are facing and how to overcome these.
Members began by turning their focus to liquidity. “Is the ETF liquid enough to be traded?” is frequently asked by members in this space, where sourcing liquidity continues to pose challenges. This is particularly true of ETF algo trading, which has grown in popularity during the last few years. “When trading algos, you need to have a very liquid underline.”
Before trading ETF algos, members consider various conditions, such as depth of book, volume profiles, product class, and the potential for alpha generation. After assessing this criteria, members then choose whether or not to go down the algo route, often partnering with one of their market makers. “There has to be sufficient liquidity for us on screen. If there isn’t that depth of book, the algo can’t really do what it is there to do: pick screen liquidity in an intelligent and automated fashion.”
One well-known benefit to algos is central clearing. However, the general feeling towards ETF algo trading remains mixed. How do you measure whether the algo was the right decision, compared to an immediate risk transfer with a RFQ?
As it stands, members are struggling to paint a full picture of trade performance and have limited insights into the impact of algos. It was argued that TWAP and VWAP trades offer some of the best insights at the moment, but more comprehensive data is needed. “It’s difficult to measure the impact you’re actually having when you do your trade over time. We’ll normally do a TWAP or VWAP trade over a certain period, and the goal is to minimise impact on the premiums or discounts.”
It’s unclear whether creating an industry-wide standard would be possible, let alone helpful. One thing for certain is that recent developments have led to much more intelligent offerings from market makers, who members seek to work closely with. “Our job is to know exactly what the algos do, who we’re trading with, and how and when they’re taking liquidity.”
When it comes to selecting a solution provider, “it’s vital to understand the value proposition and if it fits into your proprietary tech architecture”—with Tradeweb and big xyt both being mentioned as prospective ETF partners.
Establishing clear roles and remits within your team is also essential. For example, having a team that actively works with the index provider, looking at how they compose the index and ETFs themselves. “Instead of using futures, we want a more specific index which you can get with ETFs.”
Exchange vs. OTC Trades
The group agreed that greater transparency is needed for ETFs. There are also major structural differences between the US and European market that have to be addressed. “The European market is completely different to the US market given the fragmentation of the market itself, the number of exchanges, and also the nature of the clients in Europe.”
The argument for exchange vs. OTC trades further highlights these market differences. For instance, OTC RFQs are much more traditional, helping to address the fragmentation issue in the UK and Europe; RFQs are highly automated and seen as an easy way for market makers and the buy side to trade their risk. Despite this, investors are becoming increasingly curious about exchange.
The development of a single order book is helping to push exchange. The US in particular is a highly retail-focused market and concentrated on a much smaller number of products, meaning that the prospect of exchange is much greater than it is in the UK and Europe.
Our members are united in their view that exchange and OTC trades should co-exist. “Harmonisation is needed for the future, and there needs to be a willingness from both sides.”
A Date for Your Diary!
In just over a week, we’re hosting our annual Equities London Members Meeting in the heart of London, and it’s set to be a hugely insightful and inspiring day. Discover more about the meeting and our senior Equities network from The Finance Hive’s Community Manager, Grace Elliott…
After catching up with our members to gain their steer on what the perfect Equities agenda and meeting would look like over the last few months, I’m so looking forward to seeing this meeting come to life! We have ensured this in-person meeting will drive forward industry change, and made it our best meeting yet!”
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