We recently spoke with Jason Warr, Executive Director of ETF and Delta One Trading at Morgan Stanley, about providing liquidity for ETFs, the potential benefits of create-to-lend programmes and a market for short-selling ETFs, the potential vulnerabilities of ETFs, and why ETFs can’t collapse as a result of short selling activities.
Hortense Bioy: By acting as both market maker and authorised participant (AP), Morgan Stanley provides liquidity for ETFs allowing them to trade efficiently. Can you explain the difference between your two roles?
Jason Warr: Our role as an AP is to provide liquidity by creating blocks of ETFs, often known as creation units. Ordinarily that involves acquiring a basket of underlying securities and delivering those to the issuer in exchange for the ETF units. But our role as an AP often becomes more than that. We get far more involved with the issuers. So for example, we can help them with product structures, marketing and also investors’ education. Our role as a market marker is to provide quotes either on-exchange or OTC for clients to execute their business. Obviously we’ll help clients at all stages of the process, from product understanding, product selection, costs to best execution strategies to meet their objectives and their targets. Market maker and AP go often hand in hand.
Bioy: Many in the industry insist that the primary driver of ETF liquidity is the liquidity of the index’s underlying components. In reality, one of the explicit trading costs borne by investors trading on exchange is the bid-offer spread. So, if the liquidity of the underlying is such an important piece of ETF liquidity, how can two ETFs tracking the same index have very different bid-offer spreads?
Warr: It’s a very important concept for investors to understand that the liquidity of the ETF is borne by the liquidity of the underlying components or a future of these components if it is available. The spread of the ETF should be a function of this. However there are reasons why ETFs tracking the same index could have different bid-offer spreads. These reasons might include the amount of natural flow in a particular ETF, i.e. the number of buyers and sellers excluding the market makers that are participating through the exchange. It also occurs if the cost of creating or redeeming the ETFs differ between issuers; and also if the creation units size varies. Often issuers will have a minimum size of creation units that an AP can create or redeem. If this minimum size is quite large then APs may have to create more units than are required and hold the extra inventory which has additional costs. Also if one of the ETFs is listed in a currency that is different from the underlying index, that can impose an additional FX cost as well, which needs to be borne in the price of the spread.
Bioy: So if we are looking at an ETF on the EURO STOXX 50 index, one of the most liquid indices in Europe. How big can the spreads be between, say, a db x-trackers product and a new entrant?
Warr: For an index like the EURO STOXX 50, the spread of the ETF on the screen again depends on the amount of natural flow that’s going through the ETF on the exchange and it also depends on how competitive the market making is, i.e. the number of on-screen market makers that are involve in that particular ETF. If you have all these factors combined, i.e. you have lots of market makers competing with each other and lots of on-screen natural flow from natural buyers and sellers who aren’t market makers then the spread of the ETF has no reason to be wider than the spread of the underlying basket or futures. Quite often, you’ll see that ETFs have very tight spreads if all these factors are in place.
Bioy: With so many new ETFs entering the market, it’s often a challenge for issuers to garner enough assets to make a fund profitable. As both market marker and AP, how can you help market new entrants?
Warr: Often we will work with ETF issuers prior to a product launch and we will work with them on several factors. For example the structure, the costs involved in setting up and running the ETF and the costs that will be involved in the creating, redeeming and the actual trading of the ETF and also obviously ultimately the marketability. Will the ETF be accepted by investors? Do we think that it will generate assets under management? We will help issuers educating investors on the product and often join them on road shows and conferences. Then after the launch, we’d normally be a key liquidity provider, either on exchange, OTC, or both, to help stimulate trading on the product.
Bioy: Between 50% and 80%--depending on the estimates--of ETF trading volume in Europe currently takes place in the over the counter market because of limited liquidity or depth on the major exchanges. A lot of OTC investors are waiting for on-exchange trading volume to increase before they’ll take their business to the exchanges, so we are in a chicken and egg situation. What needs to happen to improve on-exchange liquidity? What class of investors do you think will start to bring more liquidity to the market?
Warr: I think the key thing here is transparency. Morgan Stanley voluntarily reports all of our OTC ETF trading and hopefully the prospective changes to MIFID will mean that other market participants will need to do the same. This increased transparency should help on-exchange volumes. Also, continuing the education of investors through road shows, conferences, is key to improving their understanding of the products and ultimately their confidence in trading them. We’ve already seen an increased involvement in the ETF market from hedge funds and this looks set to continue. But we would also like to see an increase in institutional involvement. ETFs, as a proportion of mutual fund assets in Europe, are approximately half of those in the US. We are also quite hopeful that the FSA’s retail distribution review, which highlights ETFs as an appropriate product for private investors, will help stimulate more retail interest in ETFs.
Bioy: How would you, as both market maker and authorised participant, respond to an extraordinary event, say, something akin to the “Flash Crash” that hit U.S. markets in May?
Warr: The reasons behind the flash crash in the US are not yet fully understood so it’s hard to say that it will never happen here in Europe but there are some safety catches in place which should help. For example, exchanges such as the LSE and Xetra have volatility interruptions to halt the trading in ETFs to give market participants the chance to change, add or delete quotes. Market makers like Morgan Stanley have to operate under these exchange rules. They also require us to supply two-way quotes in a minimum size with a maximum spread throughout the trading session. The pricing of larger ETF trades OTC may widen to reflect increased volatility that may exist in the underlying market of the ETF Hopefully these volatility interruptions and the obligations of the exchange market makers should mitigate the possibility of it happening in Europe.
Bioy: The structure and functioning of ETFs is dependent on market makers and APs. Some investors might see this as a potential vulnerability of ETFs as an investment vehicle. Do you believe that to be the case?
Warr: It’s true to say that in some cases, the market makers and the APs are needed to provide liquidity but in many cases this is only the first step. As ETFs gain in popularity, the presence of the market makers and APs becomes less important. The increased number of participants in the European ETF market has helped to reduce the dependence on any single market maker or AP and that should give investors more confidence.
Bioy: How many ETF providers does Morgan Stanley work with as AP? The European ETF market is not as developed as in the US. Does that mean that the AP business is less competitive on this side of the Atlantic? What would be the benefits of increased competition amongst market makers?
Warr: In Europe, Morgan Stanley works with 17 ETF issuers. Obviously some aspects of the ETF market are not as developed in Europe as they are in the US. On-exchange liquidity is an example of that. But there definitely is real competition between APs. The number of APs each issuer can choose can vary but if we take iShares as an example they have over 50 APs in Europe, which is up from about 30 about three years ago so they have seen a tremendous increase in the number of authorised participants. Now given there are many more market makers than there are APs, it’s clear that pricing has become very competitive. This increased competition is leading to a tightening of spreads and an increase in volumes, both on exchange and OTC. And there is no reason to believe that trend is not going to continue.
Bioy: Hedge funds are increasingly using ETFs for purposes such as cash equitisation and to make directional bets. Can you tell us about the “create-to-lend programme” which enables them to easily short ETFs?
Warr: The create-to-lend is simply a method by which APs like ourselves will create ETF units with the issuer and we will lend those to a client who wants to get short exposure to that ETF. Create-to-lend programmes are ultimately helping to improve liquidity by encouraging the involvement of participants, the ones who want to get short an ETF but are unable to borrow from existing holders. Generally these clients work with much shorter time horizons so liquidity and the bid-offer spreads can be improved by their participation in the market.
Bioy: Can an ETF collapse as a result of short selling practices? A white paper posted to the FT Alphaville blog a few weeks ago created a stir in the ETF industry. The author asserted that when the number of shares that have been shorted is larger than the number of shares outstanding, it creates the possibility of a “run on an ETF”, where assets held by the ETF issuer could become insufficient to meet redemptions.
Warr: The short interest is greater only because of the lending that is going on between different counterparties. If someone wants to sell an ETF, they must borrow that ETF from a long holder in order to facilitate settlement of the sell trade. If they can’t locate borrow then someone has to create on their behalf to facilitate settlement of their sell trade. This creating-to-lend generates new assets in the fund. The person at the start of that chain who physically sold the ETF doesn’t have a problem. The person at the end of the ETF who physically buys it doesn’t have a problem either. If there are lots of counterparties in between, who have bought and sold from each other on lending agreements, without physically owning it, it could be fair to assume that these are more sophisticated investors that understand the terms at which they lent into and lent out these products. The scenario the author was concerned about was that the investor at the end of the process might not be able to redeem their ETFs. This is not the case. In the US, the DTC ensures the settlement of all ETFs. So if the ETF is traded it should settle. If the ETF settles it means that you will physically own it. And if you physically own it you can physically redeem it. Now I am not saying that an ETF can’t collapse--all investment products involve risks--but the borrowing and lending of ETF shares does not create the sort of systemic risk the author suggests.
