“The first question before launching a passive or an active ETF is: what will be the liquidity and its cost,” said Olivier Paquier, global head of ETF sales at Axa Investment Managers. It does not stop there. Liquidity must be maintained and facilitated by market makers hired by ETF issuers. “Our no-go commercial threshold is when the ETF is too expensive or hard to understand or liquidity is too costly or too complex to get.”
He explained that, as a rule, liquidity on active ETFs must be at least as good as for passive ETFs when Axa IM commercialises its products. “One of the limits of active ETFs is their liquidity.”
Paquier said that liquidity discussions with market makers start “at the beginning of an idea,” before the concept moves to the construction and the start-up phases. The authorised participants (APs) may already warn ETF issuers about the excessive cost or expected inability to maintain liquidity.
Market makers: a generic role for three distinct activities
First, brokers provide “natural liquidity,” i.e., based on the offer and demand of ETFs on the stock exchange.
Second, liquidity providers (LPs) produce stock market liquidity by assuming three roles, which are outlined in the contract between LPs and exchanges. “LPs ensure presence” during the trading hours of each exchange, comply with pre-set levels of bid-ask spreads and offer minimum sizes for a smooth trading of an ETF throughout the day.
Third, authorised participants (APs) are active on the over-the-counter (OTC) market. Having signed contracts with asset management companies, APs are committed to provide liquidity in the OTC market.
The ETF may stand for ‘exchange-traded funds’ yet 90% of the ETF trading in Europe goes through the OTC market
The usual well-known global broker-dealers can play all three roles. In market parlance, “trading through a market maker refer to trading with LPs or APs,” remarked Paquier.
The appropriate market maker depends on the type of investor
Paquier commented that “retail” investors generally give their orders to a stock exchange via a broker (less than one million euros, dollars, pounds, francs, etc). In that category, he included the “deep retail,” wealth managers, discretionary portfolio management (DPM) and small funds of fund managers.
For larger positions, one can do “block trading” or “trade at Nav” on the OTC market. “The ETF may stand for ‘exchange-traded funds’ yet 90% of the ETF trading in Europe goes through the OTC market... the stock exchange is simply a showcase,” observed Paquier. A large institutional trade on the stock exchange may wipe out liquidity. “Block trading” enables a real time execution of a transaction. It means that the broker takes over the counterparty risk and guarantees the delivery of the stock.
Lastly, the market risk is assumed by investors as they are effectively “trading at--an unknown--Nav” level as when leaving an order for a traditional investment fund. Indeed, “you leave your order for, say 100,000 shares of ETF ABC [with an AP], and you get your trade confirmation at 5am or 6am and the Nav that you paid.”
What about the cost for the various options
For illustrative purposes, he explained that buying €30m of the Axa IM Nasdaq 100 ETF through a stockbroker would cost 6pbs against 4bps and 2bps for block and Nav tradings, respectively.
"[Institutional] investors should rely only on bid-ask spreads coming from competent brokers,” opined Paquier. He noted that OTC trading is sometime close to 100% of total traded volume for some ETFs giving investors a poor visibility on liquidity when only looking at the bid-ask spread on the stock exchange.
Brokers are generally used to efficiently execute ETFs. “There are some which do not care such as request for quotes (RFQ) platforms… where it is all about price,” stated Paquier. For very large transactions such for half a billion of emerging market debt, “I had to work out my order as we say in the market… i.e., finding the best time in the day to give the order or split the order over several days, etc.”
“All transactions on ETFs are visible on the stock market in the US. OTCs are not visible in Europe,” observed Paquier. He takes comfort that the EU plans to implement a so-called “consolidated tape” in Markets in Financial Instruments Regulation (MiFIR) to automatically report all transactions from the EU to stock markets, every day.
The ETF market is also a people business
“As for any ETF issuer, we guide professional investors based on our knowledge of APs’ trading book--to buy or sell--ETFs,” remarked Paquier. Of course, investors must have open lines with the relevant APs to enhance their flexibility. “We will not earn more money. All I care is that my client’s order is well executed.”
Yet Axa IM will not advise retail clients apart from suggesting them to contact their broker or private banker, who should be familiar with the liquidity of ETFs. On the other hand, Axa IM’s capital market unit may advise brokers or private bankers. Paquier thinks that banks normally have lists of pre-approved ETFs with various criteria such as liquidity.
Otherwise, as for all its competitors, Paquier explained that its capital market unit ensures that APs monitor alerts on liquidity, among other features, on each share class and in each market.
Paquier noted that ETF trading has exploded in self-directed-investment applications. Moreover, he added that ESG criteria are extensively accounted for and the new generation wants to see their portfolio in real time as it does with its cryptos. Speaking of which, Paquier suggested that we are not about to see an ETF based on cryptos in Europe.