On May 13, RIMES hosted a virtual panel discussion on the topic of the Exchange-Traded Fund (ETF) market and how it is behaving in the stressed market conditions resulting from the COVID-19 pandemic.
The session was hosted by Andrew Barnett, Global Head of Product Strategy at RIMES, and featured Bhaven Patel, Director and Xtrackers ETP Capital Markets Specialist at DWS; Paolo Giulianini, an ETF Expert with a background in ETF trading; and Marc Knowles Head of ETF and Indexing at Alpha FMC. The following is a summary of the main themes raised in the debate.
20 years of ETF trading in Europe
The ETF market in Europe has operated as an ecosystem from the outset; marked by close collaboration between custodians, ETF issuers, exchanges and index providers. Initially driven by national ETF issuers, over time the European market has become interconnected through cross-listings and as market makers have ported products in multiple exchanges. Concurrently, a market that once focused only on blue-chip indexes has broadened to encompass fixed income, commodities and other asset classes.
The ETF market is now growing fast, due to two main drivers. First, the ETF market is more efficient than it once was. As the market matured, the exchange element of the structure has become better supported and the ecosystem has evolved to such an extent that asset managers can easily source from third parties everything they need to launch an ETF. Second, new market segments have fuelled interest in ETFs. Today, ETFs are used by a broad range of asset managers, hedge funds, central banks, and wealth advisors.
The difference between the US and European markets
ETFs are growing fast in both the US and Europe, but there are a number of differences between the two markets. In the US, ETFs are almost exclusively traded on the exchange. This is because the US is a single country operating in one currency and using a seamless settlement process.
In Europe, on the other hand, the ETF market is spread across multiple exchanges supporting different currencies and with only limited – although improving – integration of settlement. This fragmentation has meant that historically ETFs have also been traded OTC and off-exchange. Issuers are now working on initiatives to reduce the number of Central Securities Depositories involved in settlements, such as through the International Central Securities Depository (ICSD) project. It is hoped that integration of CSDs will help improve liquidity in the European ETF market.
ETFs in times of crisis
During the extreme volatility experienced during the COVID-19 crisis, ETFs have behaved as expected. There are three elements to this story that highlight why ETFs are a good investment vehicle during stressed conditions:
- Pricing operated as expected: throughout the volatility, ETF prices have continued to reflect the spread of the underlying basket. As a result, ETFs have operated as a price discovery tool.
- Arbitrage operated as normal: Authorized Participants were able to arbitrage away any mispricing of the underlying securities they were tracking.
- Secondary market provided a liquidity buffer: the secondary market also provided a cost-effective entry and exit point for investors.
European central banks and ETFs
In the US, the Fed has made headlines for its use of ETFs to help support the economy during the crisis. In Europe, ETFs are not yet being used as a monetary tool, but it is perhaps just a matter of time.
European central banks are already comfortable with ETFs and have traded them for a long time. This acts as an unofficial stamp of approval for ETFs and indicates to the broader investor community that the central banks have faith in the structure for trading liquidity. ETFs are clearly no longer a niche product and it’s likely that most asset managers that do not yet have an ETF product will do soon.
Data and ETFs during the crisis
The turbulence caused by the pandemic has impacted data and index providers, who have had to delay their rebalancing schedules even as they factor in macroeconomic changes, such as the cancellation of dividend payments by corporates around the world. ETF issuers are challenged to keep track of these changes and ensure that they are reflected in their products.
Any errors in tracking risks departing from the index and potentially losing out to competitors that have been better able to keep on top of the evolving situation.
The crisis has also shone a light on the importance of holdings data for firms to gain an accurate understanding of their risk exposure under an ETF.
ETFs in Europe: the next 20 years
As the market continues to mature over the next twenty years, it will be essential for a pan-European consolidated tape to enable wealth managers to trade more effectively across the continent. Indeed, there will need to be a broad technology refresh to ensure the primary market processes are technically capable of supporting further growth.
With this in place, it’s likely the market structure will evolve to incorporate more exchange trading. Hopefully, there will be an increase in new ETFs from asset managers as they see the virtues of the structure. This could potentially include semi-transparent active ETFs and listed and non-listed share classes.
Contact RIMES to find out how we can help you streamline ETF data capture, eliminate costly internal processes and enable daily exposure insight, aggregation and reporting.
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