It’s been nearly a year since the Knight Capital debacle. On August 1, the massive exchange-traded fund (ETF) market-maker experienced a trading glitch that flooded the New York Stock Exchange (NYSE) with orders and sent some 150 stocks on a crazy up and down roller-coaster ride. While the incident was a disaster for Knight Capital (it posted a $389.1-million trading loss), it was also a disaster for some less-liquid ETFs that saw spreads balloon.
But it was also a teachable moment for investors—the Knight Capital trading glitch brought one little known area of the ETF world roaring into the headlines. Investors learned first-hand the important role that market-makers play in keeping the ETF market liquid.
Market-makers are vital to the ETF ecosystem—it’s their job to help maintain liquidity by offering to buy or sell ETF units when no one else will. They also help out by setting bid and ask prices on units—a key service.
Without market-makers, liquidity would be a huge issue for ETF investors—they take a lot of the risk out of the market by stepping in to mop up excess liquidity when it appears.
Nearly a year after the Knight Capital glitch, two major stock exchanges have taken big steps to help market-makers do their job better. Last week, the U.S. Securities and Exchange Commission gave the go-ahead to the NYSE to implement a market-maker incentive program to help improve liquidity and efficiency in the trading of some smaller ETFs. The one-year pilot program will see fund issuers pay between $10,000 and $40,000 per ETF annually to provide lead market-makers with fixed quarterly payments for doing the job.
Of course, it’s a big win for market-makers. Right now, getting paid can be tough—lead market-makers have to hit monthly quoting obligations, and that makes it difficult for anyone to get excited about buying and selling some of the smaller ETFs, especially during volatile periods. As such, it’s hoped that the program will give a big boost to smaller ETFs looking for liquidity as they grow assets. Apparently, Nasdaq is working on a similar program.
Across the Atlantic, the London Stock Exchange (LSE) is also looking to make market-makers happy. Earlier this month, it announced it’s cutting fees for registered market-makers in ETFs by 50%. The LSE is aiming to attract more ETF dealers by boosting liquidity. Doing that is good for business, and it will give the LSE a competitive edge when it comes to attracting issuers in the European marketplace.
As exchanges look to attract more ETF issuers and boost business in tough markets, it should be good news for investors. More liquidity is welcome. And lower fees and incentives for market-makers could just help smaller ETFs grow up faster (and get bigger). At the same time, as market-makers play a growing and crucial role in the expanding ETF universe, it’s going to be important for investors—especially plan sponsors—to understand how they do their job and how they impact liquidity.