Simon Barriball, Head of ETP Trading in Europe for ITG, writes that MiFID II could be a blessing in disguise with the right approach to best execution.
Right now, the European ETF market structure is somewhat opaque. This is primarily caused by the current lack of a reporting requirement for ETF transactions. In addition, due to lower on-exchange volume, as much as 70 per cent of all secondary market ETF trades are executed off -exchange on an OTC basis typically via a Request for Quote (RFQ) platform.
This absence of trade reporting creates a lack of price discovery and transparency, as a significant part of ETF traded volume goes unreported. This may hinder investor engagement, as the lack of price transparency makes it difficult to understand trading costs.
MiFID II will help to address the opacity in ETFs by requiring post trade reporting of all secondary market ETF transactions. Trade reporting will likely be a significant boost to the European ETF market – as investors will be able to better understand the true level of trading and liquidity. This should continue to support the strong AUM growth that we have seen in recent years.
It is also possible that the increased transparency will be a boost for the ETF lending market across Europe. The greater openness should enable ETFs to become more widely accepted as collateral and made more readily available for lending. It is estimated that just 5 per cent of European ETFs are used for lending compared with an estimate of 25-30 per cent in the US. Improvements in the availability of ETF lending will likely improve liquidity provision on and off exchange and help to tighten spreads.
MiFID II will not, however, transform the European market overnight. The majority of trading will continue away from the primary lit exchange. RFQ Platforms still serve a valuable purpose, and will continue to account for the majority of traded volume. All the leading RFQ platforms are likely to convert to MTF status post MiFID II. There may be elements of MiFID II that will have some unplanned outcomes.
The devil is in the detail: the original MiFID required firms to take “all reasonable steps” to achieve the best possible results for their clients. Under MiFID II firms will instead be required to take “all sufficient steps” to achieve the best possible results for their clients. The continued lack of on exchange ETF volume combined with this requirement will likely accelerate the uptake of RFQ Platforms as clients attempt to ensure that all elements of best execution are documented.
It’s an understandable move. After all, RFQ platforms have made life far easier to trade off-exchange and are also crucial in helping dealers demonstrate and document best execution of OTC trades via a competitive quote. Despite the obvious benefits of RFQ platforms it is essential traders continue to weigh up the best method of execution on a case by case basis and do not fall into a “one size fits all” methodology that results in all orders being executed in the same way.
Data from the LSE shows that on exchange trading in the first six months of the year totalled GBP38.9 billion, up 8 per cent compared to 2016, but total volume including OTC trades was GBP136.3 billion and up 16 per cent compared to 2016. This is evidence that the growth of OTC trading continues to outpace the growth of on exchange trading.
Exchanges and ETF issuers have consistently voiced their desire to see on exchange liquidity grow in Europe. Many commentators highlight the difference between the higher levels of on exchange liquidity in the US ETF market vs the European market as being a factor in a lower level of investor engagement in European ETFs. If RFQ volumes continue to grow faster than exchange volumes this development would negate some of the transparency benefits of MiFID II. If this was to happen it is likely that exchanges and ETF issuers would voice their concerns to regulators. It is possible that legislation could follow to redress the balance between exchange and RFQ volumes.
It is essential that dealers apply the same disciplines to ETF trading that they would to equity trading and consider all the liquidity options available and avoid routing orders via a simple box ticking best execution process.
A crucial step will be using the enhanced trade transparency offered by MiFID II to augment Transaction Cost Analysis (TCA), in the ETF space. By presenting investors with TCA that can evidence the costs of trading via an RFQ vs on exchange it will be possible for investors to make more informed trading decisions which fully embrace the intentions of best execution.
After arming themselves with data, firms can also benefit from impartial third-party advice from partners that know what liquidity is out there and where to find it. With those elements in place, investors can make decisions on best execution for clients and back up those decisions with hard data.
By doing so, we can ensure the proper balance of trading between RFQ and primary exchange trading. If we get that right, the post-MiFID II environment might be a very good one for European ETFs indeed.