Sweeping reforms set to take effect in 2018 could accelerate growth in European exchange-traded funds as reporting rules amalgamate fragmented exchange liquidity and cast light on an “invisible” portion of the market that currently trades over the counter.
After being excluded from the original Markets in Financial Instruments Directive in 2007, ETFs are being rolled into MiFID II where they will be subject to post-trade transparency requirements that require all exchange and OTC trades to be reported to regulators.
Participants believe that greater clarity around liquidity could turbo-charge a market that already enjoyed double-digit growth in 2016. According to BlackRock data, US$53bn flowed into European ETFs in 2016, but with assets under management of US$565bn, Europe is still dwarfed by the US$2.5trn US market.
“MiFID II could potentially have a major impact on the ETF market,” said Adriano Pace, managing director for equity derivatives at Tradeweb. “By shedding light on the bigger portion of ETF activity that trades over the counter, the instruments will appear more liquid than they are perceived to be today.”
As much as 70% of European ETF trading takes place away from exchanges, according to industry estimates. While much of that activity currently slips under the radar entirely, Tradeweb captures a significant portion on its electronic request-for-quote platform, which is home to around half of all electronic OTC dealer-to-client execution, the firm estimates.
“Europe’s ETF market is a largely institutional space and many clients want to trade much bigger blocks than you can do on an exchange,” said Pace. “Exchange liquidity can often be limited to sizes of £200,000-£500,000 and up to £1m in some of the most active products.”
Tradeweb, which is part-owned by Thomson Reuters – IFR’s parent company, provides clients with on-screen quotes from up to five dealers, handling larger blocks of up to €10m or €20m.
SPLIT LISTINGS
Mandatory reporting could also provide greater clarity over exchange-traded volume, which is fragmented as a result of multiple listings across jurisdictions and currencies – a perennial headache for ETF issuers when it comes to promoting the liquidity characteristics of their products.
“ETF liquidity in Europe has always been very fragmented because products list on multiple exchanges, each with their own set of reporting requirements,” said Manooj Mistry, Deutsche Asset Management’s head of passive, EMEA. “We’re hopeful that MiFID II will create a consistent framework with consistent tickers to report both on and off-exchange trades, which would add to the perception of better liquidity.”
Deutsche’s 185 outstanding db X-trackers ETFs, for example, are split across 260 share classes and 718 separate listings. The firm’s £4bn EuroStoxx 50 UCITS ETF is traded over seven exchanges with the majority of activity seen on Deutsche Boerse and Borsa Italiana.
“The real liquidity of an ETF is the liquidity of the underlying constituents, but if you can see higher volume, there’s a snowball effect that attracts more participants,” said Mistry. “For new client segments such as pension funds, if you can see the liquidity there, it makes the transition easier.”
BEST EXECUTION
MiFID II also promotes best execution requirements, which could drive more OTC activity onto electronic platforms where dealers are put in competition for pricing and all stages of the trade are documented. According to Pace, average price improvement on Tradeweb’s ETF platform is around 3bp compared to exchange trades.
“Lots of clients spend a lot of time and resources ensuring that trades are properly documented and have gone through the process of best execution. With MiFID II there’s a strong incentive to make sure that trades are properly transcribed, which should drive a move away from single dealer quotes to a competitive environment,” said Pace.
Reporting rules may only go so far to solving Europe’s fragmentation issue, however, with consolidation in clearing and settlement seen as crucial for recreating the liquidity of the US market, where settlement is handled by DTCC.
Some participants are hoping that Deutsche Boerse’s proposed US$14bn acquisition of the London Stock Exchange could deliver that consolidation. However, recent history suggests that even a successful deal could see settlement infrastructures remain separate for the foreseeable future. Borsa Italiana retained its Monte Titoli custody and settlement system following its 2007 acquisition by LSE, while London-listed ETFs settle through Crest.