Making A Market In Exchange Traded Products
OpenMarkets | Aug 17, 2017 15:26
Originally published by OpenMarkets
Investing in equities is nice and straightforward. Company A issues shares. Investor B buys shares from Investor C. Investor B sells shares to Investor A. Investors can only buy as many shares in Company A that are available; ditto, an investor can only sell those shares where there’s a buyer ready to snap them up. The market is ‘made’ by supply and demand.
Not so for a range of exchange traded investments. Exchange traded funds (ETFs), active ETFs, warrants, futures and options, and even Australian government bonds all require the services of a market maker. While the role of market maker is broadly comparable for each type of security, there are some subtle differences.
Market makers play a significant role, to ensure that buyers and sellers in specific financial products can always price and trade those products. Just like the king makers of old, market makers create an opportunity.
Market makers provide ongoing liquidity to the markets in their instrument; the creation units or shares in the instrument for buyers, and being there to buy-back those units or shares from sellers. Through these means, a continuous market is available to investors.
Of course, market makers aren’t doing this through altruism…they profit from charging higher offer prices than bid prices; this difference is called ‘the spread’. ASX puts limits on the maximum spreads that a market maker can quote when making a market. Generally, more than one market maker acts for each security; after all, competition keeps all parties on their toes (and keeps the spread nice and tight).
Both ASX and Chi-X incentivise market makers to promote tight spreads and liquidity in the relevant market:
- ASX offers a market making incentive scheme, through which participants receive incentives equivalent to trading fees from ASX when achieving minimum quoting benchmarks each month.
- Chi-X provides concessional fee treatment for its registered market makers, and requires minimum market making liquidity in specified funds to be eligible for concessions.
Whether trading on ASX or Chi-X, warrant issuers are required to ‘make a market’ in all warrants they have on issue – and on an ongoing basis. Issuers must ensure that a reasonable bid and reasonable volume are maintained in the market for a ‘prescribed period’, defined as 90% of the time between 10.15 am the close of trade on any trading day.
There is one circumstance where this rule may be relaxed – if the initial issue of warrants generates a sufficient spread of holders; in other words, there’s an adequate level of interest to ensure a liquid market for buyers and sellers of the warrant series. If that ceases to be, the issuer must step in to make the market. According to ASX, most warrant issuers choose to meet their obligations by making a market.
h2 Options/h2
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ASX offers a market making incentive scheme, which has six appointed market makers, to promote liquidity in single stock exchange traded options. The incentive provides fee rebates and a share of a revenue pool; to qualify, the market maker has to achieve benchmark quoting requirements to ensure liquidity in the market so traders can easily trade into and out of option positions. Liquidity also helps investors and traders price options.
Market Makers compete against one another while trading on their own accounts; this way, liquidity is assured and investors get competitive pricing.
h2 ETPs/h2Exchange Traded Products span ETFs, structured products, and managed funds; each is an open-ended product, so the number of units on issue is not fixed but will fluctuate in response to supply and demand. Both ASX and Chi-X have market makers that work with each respective exchange to facilitate trading in a range of ETPs.
This process of creating units for buyers and buying back units from sellers helps ETPs trade at, or near, their net asset value (NAV). Market makers can add to, or withdraw from, the supply of ETP units by trading directly with the product issuer.
If investor demand exceeds current ‘on screen’ availability, the market maker simply creates more units, which are issued by the ETP issuer, to meet the demand. Similarly, for sellers where there are no buyers in the market, the market maker can redeem their units.
Both ASX and Chi-X offer market making incentive schemes for participants to maintain prices and liquidity. As with incentives across other product types, market makers receive benefits when their benchmarks for quoted prices and minimum trading volumes are achieved.
h2 Active ETFs/h2While there remains some confusion around the nomenclature, active ETFs (which also go by Exchange Quoted Managed Funds or Exchange Traded Managed Funds) are essentially a listed managed fund that is actively managed. There may, one day, be agreement on what to call the growing number of products in this category!
Like their simpler cousin, the ETF, Active ETFs also require a market maker; the key difference is that in this case, the fund manager is usually appointed as market maker.
Using Schroders (LON:SDR) GROW as an example, as the market maker Schroders must ensure two things:
- There is liquidity in GROW units
- The bid-offer spreads paid by investors are close to the value of the underlying assets or adjusted intraday indicative net asset valuation (iNAV).
Schroders does this by actively issuing and redeeming GROW units to reflect, as closely as possible, the requested buy and sell trades occurring on the ASX. Schroders has created the following diagram to illustrate the market-making process.
As the market maker for units in GROW, Schroders would expect the price to trade within a tight spread around the Adjusted iNAV – in other words, under normal market conditions, investors could buy or sell units at prices close to the latest value of the underlying assets rather than waiting for confirmation of today’s price tomorrow. This, of course, is how unlisted managed funds work.
The Adjusted iNAV, which is calculated every 15 seconds, reflects the latest indicative valuation of all the assets held by the GROW portfolio, and prices are published throughout each trading day on Schroders website. Caveat: this is how Schroders undertakes its market making obligations. It does not suggest that other fund managers with a market making role, or other market makers for active ETFs, do the same. However, I’d feel comfortable wagering it’s a similar process.
So that’s market making in a nutshell. Despite the differences across product types, market making fulfils three crucial functions: it ensures liquidity, keeps the spreads tight, and importantly, lets investors buy and sell as required.
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Before deciding to trade in financial instrument or cryptocurrencies you should be fully informed of the risks and costs associated with trading the financial markets, carefully consider your investment objectives, level of experience, and risk appetite, and seek professional advice where needed.
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