Understanding Market Making for ETFs

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.