The Big Systemic Market Structure ETF Risk that No One is Talking About. Yet.
If you’ve been in the ETF game for more than a minute, you’ve seen a handful of spicy hot takes that seem to circulate on an eighteen-month cycle, without ever being solved or resolved. Here are a few of the most noticeable ones:
- ETFs are driving the market (simultaneously causing too much and too little volatility)
- There are too many ETFs out there (also: too many books at the library, too many ice cream flavors at Baskin Robbins, and too many young people in love. Now get off my lawn!)
- An SEC ETF-specific rule is being discussed (after 78 years, perhaps the “1940 Act” is due for an update)
- Market fragmentation is steadily increasing
- Non-transparent active ETFs are imminent
- Leveraged and inverse ETFs are causing male pattern baldness, keeping the snow plow guy from getting to your driveway before work, and slowing down your iPhone. And if we want to bring ETNs into it then we can blame the whole lot for the level of discourse on social media, the fact that your nephew bought bitcoin when you told him not to, and that you only get randomly selected by the TSA when you are running late.
But there is one thing that does not get the attention it should: The entire $5 Trillion ETF market is standing on the shoulders of only a handful of trading firms. A handful of underpaid and under-incentivized market makers.
FINRA put out a request for comment for the ETF industry to weigh in on lifting a rule that was put in place long before ETFs were recognized as the vehicle of choice for the modern investor, a rule that prevents firms like mine – ETF issuers – to properly incentivize market makers. If you are a details type, you can read their notice here.
What I neglected to do in my comment letter was to walk through the math to show people just how serious the problem is. So, indulge me:
The average ETF trades about 640,000 shares per day, but that number is vastly skewed due to the trading tools that top the list by that metric. Buy-and-hold funds trade substantially less and make up the majority of ETFs. The MEDIAN ADV (Average Daily Volume) is just under 19,000 shares per day. We’ll round up. Let’s call it 20,000 shares per day.
Market makers are compensated through a maker-taker model, paid for providing liquidity and paying in for taking away liquidity. Those rebates are enhanced when taking on market maker obligations, which include a continuous quoting of a two-sided market. But that doesn’t mean that they get paid on 20,000 shares in our example.
We’ll use NYSE* market maker rebates numbers, and we’ll use best-case numbers. For a fund that trades less than $1m CADV (Consolidated Average Daily Volume), the rebate is .0045 cents per 100 shares traded. The fee for removing liquidity is .0029. Let’s assume the market maker only provides and never removes liquidity. Let’s also give them the .0004 extra rebate for taking on 300 or more ETFs – the highest possible rebate amount. Well, NYSE only gets 22% of ETF trading these days – amazingly the highest number of any exchange (Cboe is arguably higher when combining their venues, depending on who sources the data). We are going to round the exchange venue up to a full 25% of the volume. Now, the market maker participation rate can vary widely. Those participation rates are not published publicly, but anecdotally tend to range anywhere from 10%-50%. Let’s give them 50%. But, now we have to subtract the .0030 rebate that a market maker receives for providing liquidity opportunistically, without the obligations of being lead. I may have lost you here, trying to keep it simple, but this you’ll get: the rebate difference for an LMM taking on a median volume ETF comes out to $4.75 per day. Four dollars. And seventy five cents.
*Off topic, but in the interest of full disclosure, I spent six years at NYSE and at one time had oversight over the market maker payment program. I loved that place about as much as an employee can love an employer, a brand and a building. I can’t say enough about how much I learned during my time there, how special the building and the people are, and how rich the history is. After six years, walking down Wall Street and into the building felt as special as it did on my first day. If I cut down some bridges or burned some boats on my way out, it was done as a message to myself: I’ll have no choice but to find a way to make Exponential work because there is no turning back. So long, suckers, I’ll build something of my own or die trying.
Ok, back to the topic at hand. And it gets worse. Look at the concentration of market makers:
According to data provided by NYSE, as of February 1, the top five market making firms (by products allocated) had 87% of the allocated market share! That is a higher concentration than we even see in market cap weighted index funds. What is critical here, is that if one of those firms falls, by strategic choice or by a rogue trader, that there is another willing to step in and take their place. At $4.75 per day, don’t hold your breath.
You have to consider that there is a significant cost to acting as market maker. Sure, there is a cost of capital, cost to hedge, expense ratio drag, create/redeem fees, nagging calls from issuers looking for tighter spreads… but mostly there is risk. Risk of mispricing, risk of being exposed during an extreme market event, risk of having to show your quotes.
“But do you trust them”? That was said to me by the smartest ETF analyst in the industry when I told him that there were a couple dozen HFT firms that have market making capabilities, but are on the sidelines because the incentives aren’t there. HFTs might be the bogeyman under your preschooler’s bed when it comes to stocks, but for ETFs they provide value.
ETFs are derivatively priced meaning that the value of an ETF in real time is derived by the value of the underlying securities. It is easy to price ETFs that track large and liquid stocks – holdings are posted daily, underlying index values tick throughout the day, IOPV/iNav values are disseminated in real time, and every serious ETF trader has the capability to price an ETF in real time based off these tools. ETFs that track securities that don’t offer transactional values in real time (such as corporate bonds or foreign markets that are closed during US market hours) can be estimated using a variety of methods such as spreads, index levels and correlations, etc. So, if a market maker WANTED to manipulate the price of an ETF, they would have to either price the bid above fair value, or the offer below it, which immediately makes them vulnerable to the rest of the market to trade against them. So yes, I trust HFTs. I trust them to act in their own interests, which happen to coincide with the interests of my clients who are the end-investors.
We have seen a few market making firms exit the business in recent years, for a variety of reasons. And every time that happened, another firm has been willing to step up in their place. But the day could very well come where there is no firm stepping up. For four bucks and seventy-five cents per day, why would they?
Posted by: Phil Bak 02/28/2018