Two years ago Simon Barriball arrived as Managing Director, Head of Exchange Traded Products at agency broker ITG charged with building a high touch ETF trading desk for its European institutional clients.
Barriball says: “The motivation in setting the desk up was to deal with two issues that clients face in Europe: one is a lack of transparency on trading due to a lack of trading reporting which makes it difficult to gauge trading costs, and the market is very fragmented with roughly 70 per cent traded off-exchange.
“We felt there was a real role to do a bit of handholding for clients and help them make the right decision on trading. As an agency broker, we don’t have proprietary trading and we have no ETF marketmaking business which means we give unconflicted advice.
“We provide an execution service on an agency basis. We have no principal positions which means we can give unconflicted advice.
Barriball also believes that they are well-placed to connect clients to the right sources of liquidity in the market. “Broking lists for ETFs should look different than that for equities because the people who are the key liquidity providers in the ETF space are not necessarily the same as those who provide liquidity for equities.”
Barriball makes the point that post-2008 investment banks have contracting balance sheets so are less active liquidity providers in ETFs.
“Non-bank proprietary trading companies have increasingly become the go-to liquidity providers in the market and, in some instances, it’s difficult for clients to have direct relationships with all of those brokers because there may not be room on the broking list for single product specialists or it may be difficult from a compliance point of view.”
Barriball points out that ITG has relationships with 15 marketmakers of whom 12 are non-bank, so a client can access the liquidity of all those brokers by trading with ITG.
“We also offer a high touch service with sales traders sat here who can talk you through the process and give you advice and analyse trading options– it’s an added value service for clients, we don’t view ourselves as a black box”
The lack of on-exchange liquidity in European ETFs is a constant issue and one that Barriball believes will increase not decrease and is holding back the growth of the European ETF markets.
In his recent paper on the subject, entitled ‘ETFs – what’s in a name? For European ETFs, a lot of confusion’, Barriball explains: “The name should say it all ‘Exchange Traded Fund’. You would reasonably expect that a fund describing itself as an Exchange Traded Fund would do just that – trade on exchange. The reality in Europe is quite different. Best estimates of European trading are that 50-70 per cent of all ETF trading is off exchange on an OTC basis. One could therefore argue that ETFs fail to live up to their name.”
And this matters, Barriball says because the US and the European ETF markets are quite different. “The US market is broadly characterised by a high level of on exchange liquidity with ETFs accounting for approximately 30 per cent of total equity market turnover. US ETFs are listed in a single currency, covered by one set of regulations and cleared in a single depository. In addition ETF usage is predominantly a retail tool with retail turnover accounting for as much as 70 per cent of turnover.
"The European picture is quite different. ETFs are typically listed on multiple exchanges, sometimes in more than once currency and settled across the different domestic settlement systems of each market. ETFs are generally an institutional tool with institutional activity accounting for as much as 70 per cent of trading. The structure in Europe creates a highly fragmented liquidity pool where it is costly and time consuming to move inventory from one settlement depository to another. This creates wider spreads and a lack of on screen liquidity. This lack of liquidity drives dealers to source block liquidity away from the exchange via an OTC broker.”
For Barriball, a lack of on exchange liquidity is a significant barrier to trading. “Currently, regulators do not require details of ETF trades to be reported although the LSE does demand that member firms report trades and MiFID II will rightly make this standard practice. This lack of trade reporting creates a lack of price discovery and transparency, as a significant part of ETF traded volume goes unreported. This lack of on exchange volume and transparency is a significant barrier to investor engagement. Retail investors are unlikely to be aware of the workings of the OTC market and even institutional investors are put off using ETFs as the lack of price transparency makes it a significant challenge to understand trading costs. The end result is that a lack of on exchange liquidity is holding back the growth of the European ETF market.”
“Lots of clients who need to trade ETFs are forced down the off-exchange OTC route because of the lack of on-exchange liquidity,” Barriball says. “When you put in a request for prices through a platform, it’s possible to get over reliant on that and deal there and then rather than considering the liquidity dynamics of that product.”
Barriball predicts that the decision making process of where to trade ETFs in Europe will become vastly more complex over time as regulatory developments such as Mifid II and fragmentation from the proliferation of exchange-based RFQ platforms will also affect traders going forward.