This is part of a series on the global rise of exchange traded funds
ETFs are a global phenomena, but there are significant differences between the market in Europe and the US. This piece examines the most important.
The US is far bigger
Demand for exchange traded funds in Europe has never been higher. Assets held in funds and products listed across the region hit a record $567bn at the end of the third quarter, according to ETFGI, a London-based consultancy.
Such growth, however, lags far behind the US, where assets invested totalled $2.4tn for the same period. This reflects two major differences between the two regions. First, in Europe, the majority of business is off-exchange, and secondly, there are far fewer retail investors.
“When you look at the EU market, only 11 per cent of households own funds compared to over 40 per cent in the US. So it’s not surprising that European ETFs are largely the domain of institutional investors,” says Sean Tuffy, head of regulatory intelligence at Brown Brothers Harriman.
The disparities run further. Again, from ETFGI: The number of exchange traded products in the US was 1,932 compared to 2,219 in Europe. While the US had 1,932 listings from 97 providers on just three exchanges, Europe is a fragmented world of 6,953 listings from 56 providers across 25 exchanges in 21 countries.
The main European ETFs also only cover the biggest and most liquid markets — the German Dax, Euro Stoxx 50, Italy’s MIB, France’s Cac 40 and the pan-European Stoxx 50 index.
Europe’s fragmented markets: there’s little ‘E’ in ETF
US share trading on exchanges is bound together in a complex regulation known as Reg NMS. One of its stipulations is that brokers are required to route trades to the exchange that has the most competitive price for buying and selling a listed share or ETF at any given time. If more than one exchange shows the best price, the broker can choose.
Furthermore, all trades in the US have to be reported to a publicly available source. A notable aspect of Mifid, Europe’s 2007 markets regulation, is that it did not recognise ETFs as an asset class. Therefore not all transactions have to be reported and so most of the market is traded over-the-counter. The ratio of on-versus-off exchange trading in the US is 70:30, while it is widely estimated that the ratio is reversed in Europe.
The fact is that ETFs in Europe aren’t really traded on exchanges.
That suits many large institutional investors who want to be able to trade in large blocks. Independent venues like Tradeweb and Bloomberg have carved out big market shares. On Tradeweb the average trade size is €2.5m compared to €300,000-€500,000 on an exchange.
“It’s very different from the London Stock Exchange or Deutsche Börse for example, we can absorb the bigger trades,” says Adriano Pace, director of equity derivatives at Tradeweb in Europe. “The order book on exchanges are much thinner. It’s better for retail but not enough for asset managers. As a whole, off-exchange they can get the thing done.”
The opacity may benefit the broker and their asset management clients but others lose out.
“When an investor comes in and buys, that adds to the share base of the ETF. The share count goes up but the issuer doesn’t know how many trades and at what price. The issuer wants more information,” says Mr Pace.
The US has more retail investors and efficient infrastructure
In the US, returns from the stock market are still a key generator of wealth.
“One driver is that people invest their own pension money so they are much more cost-conscious than in Europe,” says Dennis Dijkstra, co-chief executive of Flow Traders, Europe’s largest ETF electronic market-maker.
And ETFs — especially outside the UK — are typically sold to investors via banks and not specialist brokers. That reinforces an institutional grip on the market in two ways.
“The banks are more likely to sell banking products rather than fund products,” says Mr Tuffy.
Mr Dijkstra notes that a local retail broker is usually a member of one or two exchanges. As institutional investors are members of many bourses, “off-exchange they will get the best price. They get the liquidity in one shot’.’
Then there is the issue of settlement. In the US, all trades are settled in one place, the Depository Trust and Clearing Corporation. By contrast the European Central Securities Depositories Association has 41 members. That is a particular problem when it comes to redeeming ETFs.
“A broker may have to move collateral between central securities depositories. It’s more time consuming and costly,” says Laura Morrison, global head of exchange-traded products at Bats Global Markets.
Then there is a matter of financial incentives. US issuers are prohibited from paying a market-maker directly for their services, preventing a conflict of interest in which trading desks profit from a product created within the same institution. Nevertheless, there are incentive schemes to attract traders. For example, issuers can make defined payments to the Bats exchange, and the market-makers compete to win the sum on offer from the third party.
No such distinction is made in Europe, where direct agreements can be made between the market makers and the issuers. “In Europe it matters, it makes a difference,” says one executive.
Changes could be afoot
An update to Mifid, which comes into effect from January 2018, mandates greater transparency for deals executed off-exchange and that includes ETFs. While it falls short of a consolidated tape of trade information, it should be a significant step forward.
The second is the introduction of Target2Securities, a major securities settlement IT project run by the European Central Bank. Its aim is to create a more unified settlement system for Europe and accelerate cross-border payments by settling deals in European Central Bank money.
That may provide a partial unblockage. The final leg — greater participation from the retail investor may be the hardest of the lot.
Age of the ETF stories