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Addressing liquidity for European ETFs

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The past 12 months have been extremely busy and exciting for Source.

The past 12 months have been extremely busy and exciting for Source. Established at the end of April 2009 by a group of leading ETF market participants, Source has already attracted more than USD4bn in 46 equity ETFs and 28 exchange-traded commodities and has now received further encouragement by being voted Best Global (ex-US) Equity ETF Manager by readers of etfexpress.

As we prepared for launch last year, it was clear that many of the factors that drove investor concerns during the financial sector turbulence in 2008 helped to highlight the benefits of Source’s unique approach to constructing ETFs. In particular, the difficult market conditions illustrated the value of Source’s open-architecture approach to delivering enhanced liquidity, increased transparency, reduced fragmentation, diminished counterparty risk and improved market performance. Today we are convinced that these characteristics remain as important as ever.

In deciding whether to enter the European exchange-traded products market with Source, our partners – which now comprise BofA Merrill Lynch, Credit Suisse, Goldman Sachs, J.P. Morgan, Morgan Stanley, Nomura, Nyenburgh, All Options, Banca IMI, Exane, Flow Traders, IMC, Knight Capital, LaBranche, Newedge, SG Securities and UniCredit – first had to consider whether the market really needed another ETF provider.

While there were already a number of good providers and products, the European market also had fundamental shortcomings that really struck us as opportunities, with very low depth of investor penetration and level of actual trading in ETFs compared with the US. Addressing these structural issues could increase the liquidity and trading frequency of our products, thereby enhancing their value.

Source identified four specific barriers to enhanced liquidity – the lack of an efficient lending market for ETFs, index construction, market fragmentation and liquidity fragmentation – and has tackled each of them.

Efficient Lending. The enormous ETF trading volumes in the US market can be attributed, in significant part, to the ease and efficiency with which investors – especially hedge funds – can borrow ETFs and sell them in the market to establish short positions. For various structural reasons, it has historically been both difficult and expensive to borrow European ETFs. Source has worked extensively with borrowers and lenders to address these structural impediments.

Index Construction. To be a valuable benchmark for an ETF, an equity index must capture the performance of the target market and allow for liquid and efficient trading, both long and short. Recognising this, Source and STOXX worked together to create the STOXX Europe 600 Optimised Supersector indices. By enhancing these sector indices through reduced concentration, increased diversification and – for the first time ever for a broadly recognised benchmark – the ability to borrow/short the underlying constituents efficiently, we created a trading tool that has been embraced by the investing community.

Fragmentation. The ultimate way to enhance liquidity is to bring buyers and sellers together in a single place to trade a common, fungible instrument. In Europe, fragmentation among product providers, listings, currencies and market participants has frustrated secondary market volumes. Source has begun to reverse this trend by focusing multiple industry participants on a common product, concentrating exchange listings and bringing significant transaction volumes out of the OTC derivatives market into our products.

Over the coming year we will continue to expand our product range and assets under management while remaining focused on the issues that brought us into this market: enhanced liquidity, transparent counterparty risk and product performance.

Ted Hood is chief executive of Source

Please click here to access the etfepxress 2010 awards special report

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