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Portfolio > ETFs > Broad Market

The Big Systemic Market Structure ETF Risk That No One Is Talking About

By Phil Bak

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Recently, FINRA put out a request for the ETF industry to comment on lifting Rule 5250 — a rule put in place long before ETFs were recognized as the vehicle of choice for the modern investor, a rule that prevents ETF issuers from properly incentivizing market makers.

As it stands today, ETF market makers are compensated through a “maker-taker” model, paid for providing liquidity and paying in for taking away liquidity. Those rebates are enhanced when taking on market maker obligations, which include continuous quoting of a two-sided market within a predefined spread range and a minimum acceptable amount of depth on the bid and ask.

While any market maker can trade ETFs opportunistically, only the lead market maker enjoys the enhanced rebates that the “LMM” programs offer. However, as market fragmentation continues, the primary listing venues where trading is eligible for the enhanced rebates only see fractional volumes.

Further, as ETFs evolve from trading instruments to buy-and-hold strategies, incentivizing by trading volume doesn’t amount to much. In fact, we ran the numbers and found the incremental rebate difference between being a lead market maker and any other market maker in a median volume ETF comes out to precisely $4.75 per day.

Compounding the problem of low incentives is the issue of market maker concentration. Eighty-seven percent of all allocated ETFs on the New York Stock Exchange are spread out among only five different market making firms.

In other words, if one of those five firms suffered, a rogue trader, a fat-finger mishap or even a strategic decision to exit the market making business, the ETF industry could see hundreds of funds without a lead market maker and without the proper incentives to entice another to step up in their place.

While investors are often mistrustful of market makers, it is important to consider that ETFs are derivatively priced, meaning the value of an ETF in real time is derived by the value of the underlying securities. ETFs that track large and liquid stocks are priced using the holdings, which are posted daily, underlying index values that tick throughout the day, and IOPV/iNav values that are disseminated in real time. These tools allow for transparent real-time pricing.

ETFs tracking securities that don’t offer transactional values in real time, such as corporate bonds or foreign markets that are closed during U.S. market hours, can be estimated using a variety of methods, such as spreads, index levels and correlations.

Thus, if a market maker wanted to manipulate the price of an ETF, they would have to either price the bid above fair value, or the offer below it, which immediately makes them vulnerable to the rest of the market to trade against them. As such, increased market maker participation in ETFs only serves to narrow spreads and make trading more efficient.

On the other hand, market makers have to weigh the costs of acting as a market maker, which include the cost of capital, cost of hedge, expense-ratio drag, create/redeem fees, risk of mispricing, risk of being exposed during an extreme market event and the risk of having to show quotes. For $4.75 per fund, it is hard to make the case that they should bother.

Our firm’s focus is to ensure a quality market for our clients to trade size at any time during the day, which includes managing market makers and ensuring that spreads are as tight as possible. By asking FINRA to exempt ETFs from Rule 5250, we are hoping to have more tools at our disposal to manage and incentivize market makers, paving the way for better trading for our clients and investors.

Phil Bak is CEO of Exponential ETFs.

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