For the pension funds that use them, exchange-traded funds (ETFs) are all about liquidity. On a laundry list of cheap and easy ways to tap different markets, ETFs stand out because they provide an essential layer of liquidity within an existing portfolio at a time when it doesn’t pay to keep cash on hand. Bottom line: ETFs are a handy way to make sure you can cash in and run for the exits when you need to.
Last summer, however, a massive trading glitch at ETF market maker Knight Capital shone a light inside the complex market-making machine that makes these products so liquid. Referred to as an “ecosystem” by iShares on its blog, the practice of market making in the ETF space involves several layers of participants, all of whom are needed to keep ETF shares ticking along every day. According to the chart on the blog (which is definitely worth reviewing), this ecosystem involves registered market makers, lead market makers, designated liquidity providers and competitive liquidity providers.
While market makers help keep the ETF ecosystem running, they can also be a barrier for smaller providers trying to nudge their way into the marketplace. So, back in April, NASDAQ made a move to address the problem by issuing a proposal to the U.S. Securities and Exchange Commission to ensure smaller ETFs are able to attract attention from market makers. The proposed program would see ETF providers pay annual fees of $50,000 to $100,000 to NASDAQ. In return, the exchange would pass those fees on to market makers as an incentive for improving trade and quote performance.
It’s an interesting concept, and it could create a more level playing field for new players in the ETF space.
NASDAQ has since submitted a new plan with a few important changes: it has tightened eligibility requirements for the program and excluded products other than ETFs from participating. The trading volume threshold has also been reduced to an average of one million shares (or fewer) from two million shares (or fewer) in the original proposal. The new proposal also adds in greater disclosure to market participants about how the program would work and which funds are participating.
The main message here: market makers are paramount to an ETF’s success. Without their support, new products simply shrivel up and die. So if liquidity is the main reason you’re buying ETFs, then it’s best to know (and understand) the many players in the ecosystem that make the market move.