MiFID II and the ETF ecosystem

When the new legislative framework MiFID II came in effect on 3 January 2018 already many hours went into the preparation from the participants of the ETF ecosystem but many more were to follow. Now one year into MiFID II we like to look into the challenges and implications with Stephan Kraus, Deutsche Boerse, and Jim Goldie, Invesco.

What has been the biggest challenge for you? 

Stephan Kraus: One of the biggest challenges was to ensure the implementation of an appropriate tick size regime for ETFs that would not curb competition and future growth prospects for the industry. Driven by developments in the equities space, regulators saw the risk that tick sizes would continue to decline due to an increasing competition of trading venues for the best execution price, without this leading to a further noticeable price improvement for investors.

However, during the consultation process it became clear that key liquidity metrics for equities like the average daily number of transactions would not be equally suitable for ETFs: such indicators typically do not account for the additional layer of liquidity available to ETF market makers through an ETF’s creation/redemption mechanism. It also became apparent that differences in the liquidity profile of equity and fixed-income ETFs would make it rather difficult to find a consistent approach applicable to both asset classes.

Finally, taking into account feedback from ETF market participants, the European Securities and Markets Authority recommended that the tick size regime should only be applied to equity ETFs. Furthermore, it was decided that ETFs falling under the regime should be assigned to the highest liquidity band available. This is quite an achievement, considering where we came from when the first proposals were presented. Nevertheless, there is room for improvement: the current regime is not yet an ideal solution for all ETFs, especially the most liquid European equity ETFs.

Jim Goldie: Whilst MiFID II presented the opportunity to demonstrate over-the-counter (OTC) liquidity in UCITS ETFs, one of the biggest challenges has been the ability to showcase that liquidity in the absence of a consolidated tape. With multiple approved publication arrangements (APAs) and reporting venues for each ETF, it is a cumbersome and data-intensive exercise to capture and consolidate all the different ways secondary market ETF volumes are reported. Internally, we have invested a lot of time and energy to be able to capture and package the abundance of available data post-MiFID II, however, for end clients we need to find a solution that allows us to present this data in a meaningful way, without the need to aggregate thousands of different data fields in order to calculate aggregated trading volumes in UCITS ETFs.

MiFID II had various implications on the market infrastructure. Will the landscape even fragment further?

Jim Goldie: The biggest change to ETF trading post-MiFID II was the adoption of request-for-quote (RFQ) platforms. Whilst this satisfies best execution in the eyes of the regulator, it does have the unintended consequence of further fragmenting the ways in which ETFs are traded. Over the course of 2018 we saw the largest portion of UCITS ETF OTC trading volumes take place on RFQ platforms such as Tradeweb and Bloomberg RFQ. What we’ve also now started to see is the exchanges bring their own RFQ platforms to market which offer the same functionality as the more established platforms, with the added benefit of having trades centrally cleared rather than bilaterally settled. We saw a wider adoption of systematic internalisers (SIs) post-MiFID II, which gives clients access to streamed, firm prices intraday, as well as the ability to trade above standard market size directly with liquidity providers. In addition, SIs are also responsible for post-trade transparency, ensuring buy-side clients that post-trade transparency obligations will be fulfilled. A large part of the USD 90 billion traded in Invesco ETFs in the secondary market in 2018, was done via SIs (about 40%), and we expect this to continue. In short, whilst clients now have a number of available options for trading ETFs post-MiFID II, it has further fragmented the OTC nature of ETF trading, rather than pushing more trading on-venue. It should be said, however, that despite MiFID II drastically changing how ETFs are traded, the impact to on-exchange trading volumes seems to have been limited, as on-screen trading volumes have remained broadly consistent in 2018.

Stephan Kraus: Indeed, the introduction of MiFID II has led to greater fragmentation of the European ETF market. Investors now have the choice between several possible execution venues, including regulated markets and exchanges, multilateral trading facilities (MTFs), SIs and – absent a trading obligation for ETFs – OTC trading. This may very well result in a higher administrative burden for investors as they have to consider and manage multiple connections to execution venues and compare the execution quality offered by these.

There has also been an uptake in RFQ trading activity since the beginning of last year as investors seek to demonstrate best execution when executing larger ETF blocks. While Deutsche Börse will launch its own dedicated RFQ service Xetra EnLight later this year to cater to investor demand, we believe that the creation of deep liquidity pools in the form of central limit order books with a broad variety of market participants is actually the most efficient way to execute ETF orders. We will therefore continue to put our focus on further growing ETF order book liquidity.

Did the client behaviour change due to the implications? 

Stephan Kraus: Given the high fragmentation of the European market, best execution considerations now play an even greater role for clients under MiFID II. Brokers have to consider several factors to achieve best execution for their clients – the execution price is only one of these factors. Other factors include costs, speed and the likelihood of execution and settlement of orders.

For example, when trading on-exchange in the order book, investors benefit from a fully transparent, multilateral trading offering. Orders are not executed against a single counterparty, as is the case in SI and OTC trading, but can simultaneously interact with the liquidity provided by a large number of trading participants. Furthermore, in terms of post-trade efficiency and likelihood of settlement, market participants take advantage of the central clearing services of central counterparties (CCPs), which help to mitigate counterparty risks, reduce settlement costs by netting off buy and sell transactions, and ensure timely settlement through a buy-in process.

We believe that these factors present a very good value proposition for order book trading under best execution considerations. Investors and trading members seem to appreciate these advantages as well: the number of executed orders in the Xetra order book jumped to 565,000 per month in 2018, a 29% increase over the previous year and a new record level for our ETF segment.

Jim Goldie: Client behaviour has changed in a number of ways. Firstly, as mentioned previously, there has been a distinct shift in how clients trade ETFs, with the broader adoption of using RFQ platforms and trading via SIs. We are also starting to see clients understanding of ETFs improve. The obligation to report OTC trading in ETFs has seen reported ETF volumes more than treble post-MiFID II. In the Invesco UCITS ETF suite, roughly 75% of ETF trading takes place OTC, most of which was not visible prior to MiFID II. As a result, it is now easier for clients to understand that ETF liquidity is not driven purely by the on-exchange volume in an ETF and that the true liquidity is driven primarily by the underlying benchmark the ETF tracks rather than the ETF itself. This has resulted in clients being more willing to adopt ETFs with less significant assets under management (AUM), without the misperception that smaller funds are less liquid. We experienced this with one of our most recent launches, the Invesco US Treasury Bond 7–10 year UCITS ETF, launched with USD 5 million AUM and our first trade was USD 400 million, which was executed with little to no market impact. Within one month from inception the fund had USD 1 billion in AUM.

Do you think MiFID II improved the overall ETF ecosystem? Who are the winners of MiFID II?

Jim Goldie: I think for most part, yes. Despite the need for improved availability of OTC data and a consolidated tape, the fact that we now have transparency in OTC reporting gives us the ability to demonstrate just how much UCITS ETFs trade on a day-to-day basis. The emergence of RFQ platforms as a means to satisfy best execution post-MiFID II has been a debated topic through 2018. There is no doubt that it has improved the ecosystem in terms of giving clients access to a large number of liquidity providers, which can result in more competitive pricing. Whilst this can improve clients ability to trade ETFs, it should also be said that RFQ platforms are not a catch-all for ETF trading, and clients should always weigh up execution options, such as on-exchange, trading with SIs, or working orders in an agency capacity. Most ETF issuers have large capital markets teams, which are teams of dedicated ETF trading and liquidity specialists that can assist clients in finding the most suitable means of execution in line with their investment objectives. The unbundling of research costs also seems to have been a win for clients. Many asset managers decided to fund research from their own revenues rather than via trading commissions, which has resulted in cost savings for the end client.

I believe the ETF industry overall has benefited post-MiFID II. The ability for clients to achieve more transparent and competitive pricing can only help improve the broader adoption of ETFs as an investment vehicle. Post-trade transparency and the ability to showcase OTC ETF trading volumes, that previously were not reported, gives clients a clearer understanding of the liquidity profile of ETFs and helps overcome some of the traditional misconceptions that smaller ETFs, or ETFs that didn’t trade much on-exchange, were not liquid. There is still a lot of education that we need to do as an industry to help achieve the growth potential of UCITS ETFs, but it feels that MiFID II has been a step in the right direction.

Stephan Kraus: One of the key aspects of MiFID II is the focus on greater transparency, which is particularly beneficial for investors. Examples include the new costs and charges provisions for investment funds and the new best execution reports to be published by trading venues. In addition, MiFID II introduced an OTC trade reporting regime, which will ultimately serve investors by providing them with a complete picture of the overall liquidity available in the European ETF market. The market is currently still struggling to consolidate the vast amount of new trading data, however, we are confident that these issues will get resolved over time.

Taking up this call for greater transparency, we recently started to calculate a new key liquidity indicator: the intraday Xetra Liquidity Measure (iXLM) provides information on how implicit trading costs of an ETF have developed over the course of a trading day. It therefore allows investors to deduce the time period in which the trading costs of an ETF were particularly low and to take this information into account for future trading decisions. A current evaluation of all ETFs has shown that investors can save on average up to 30% of these costs in ETF trading, depending on the time of day.

Outlook, what are the main areas where you are looking at for further improvements? Which topic should be the focus of MiFID III? 

Stephan Kraus: As mentioned earlier, there is still room for improvement when it comes to the ETF tick size regime. While the current regime works well for the broad majority of ETFs, it does not fully reflect the different liquidity profile of some of the most liquid equity ETFs in the European market. As a consequence, investors have to bear significantly higher implicit transaction costs in high-liquid ETFs than would be the case with a better calibrated regime.

We also believe that SIs should have to adhere to the tick size regime in order to create a level playing field between regulated markets, MTFs and SIs when competing for order flow. Currently, SIs have the opportunity to improve prices in sub-ticks, which may actually encourage further fragmentation in the European market rather than prevent it. We therefore advocate for an equal treatment of all trading venues by extending the tick size regime to SI quotes in all sizes.

Jim Goldie: I mentioned previously the lack of a consolidated tape for UCITS ETFs which makes showcasing the aggregated liquidity for ETFs difficult. The introduction of a consolidated tape will further enhance the industry’s ability to demonstrate true trading volumes in UCITS ETFs. I believe the industry will also benefit from further harmonisation with the exchanges and OTC trading/settlement. Having a consistent approach to things like the mandatory tick size regime, buy-in rules, fails costs, etc. would make markets more efficient and help improve settlement rates. Centrally clearing OTC trades, such as those done on RFQ platforms, would also provide greater efficiency and reduce counterparty risk. Focusing on these areas would help create a more robust and efficient ETF ecosystem, which could translate into improved liquidity and cost savings for clients via tighter spreads.

Commerzbank Disclaimer
The views expressed in this article are those of the author and may differ from the published views of Commerzbank Corporate Clients Research Department, the communication has been prepared separately of such department. No representations, guarantees or warranties are made by Commerzbank with regard to the accuracy, completeness or suitability of the data.