From the June 2015 issue of Investment Advisor • Subscribe!

Understanding Market Making for ETFs

Mispricing risk is highest at the open and close of the market

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Market makers must understand an ETF's holdings and value throughout the trading day. (Illustration: Wei Yan/Masterfile/Corbis) Market makers must understand an ETF's holdings and value throughout the trading day. (Illustration: Wei Yan/Masterfile/Corbis)

An ETF is easy to understand. The structure is designed to give brokerage account access to a diversified basket of stocks, bonds or other asset types. While structural similarities exist between ETFs and individual issues, there remain differences that require understanding to ensure their effective use, which includes buying and selling for both longer-term and shorter-term strategies.

Those who make markets in stocks solely react to supply and demand for a given stock. They stand between buyers and sellers, and use their own inventory to reconcile the time—and sometimes price—differences.

ETFs have an elastic supply of shares. That is, certain market participants can create (new shares that enter the market) or redeem (shares extinguished) ETF shares. Thus, ETFs are derivatives—traded instruments that derive their value from other instruments, although unlike traditional derivatives, ETF shareholders actually own a pro-rata share of the fund's underlying securities.

Given these facts, it is of the utmost importance that ETF market makers (MMs) know the holdings of an ETF, and by extension, an ETF's value throughout the trading day. This is not only important for MMs’ own profit and loss, but also so they can better manage their risk, which makes more efficient markets for advisors and individuals to trade.

The main mechanism for MMs to receive holdings data from the various ETF providers is via the National Security Clearing Corporation (NSCC) “basket” file. This is standardized and generally easy for MMs to use. However, the NSCC file can only be used for equity-based ETFs. For all other ETFs with holdings that include bonds, swaps, futures and other derivatives, the MMs must rely on specialized holdings files that are administered by each ETF sponsor. These files are not standardized in their format. Therefore, there is a risk that MMs could be mispricing some ETFs based on the data they receive.

Mispricing risk becomes particularly exacerbated right at the open of the market. During this time, MMs must reconcile all of the disparate holdings files to ensure that their electronic feeds are functioning appropriately. A mistake here could lead to monetary losses, and MMs generally do not show large quotes or particularly tight markets early in the trading day. Once they gain a higher degree of confidence that all is well with their quotes, MMs begin to show more size and tighter markets. Therefore, it is imperative to take proper risk management steps when placing trades at or near the market open.

Trading at the very end of the day also poses challenges. With any ETF trade, MMs generally hedge their exposure—usually with the underlying holdings of the ETF, but sometimes with an optimized set of instruments. For many ETFs, the cutoff time for creations and redemptions is before the close of regular trading at 4 p.m. Eastern time. Any risk exposure that cannot be offset through the creation or redemption process must be held overnight. This leads to risk that must be hedged in case the price of the holdings changes in a meaningful way. Markets, in general, can become more volatile and less liquid toward the end of the day—much more so if any hedging needs to be done after 4 p.m. For example, if MMs have an ETF quote posted, they have to execute an order and then need to get hedges in place in a volatile and illiquid market.

A key ingredient to a successful practice that can grow in the future is to make the most of what Fisher Investments’ founder Ken Fisher would call capital markets technology—such as ETFs—and then make the most of accessing that technology in an efficient and effective manner, especially in terms of cost.

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