Published by: Global Trading | 24th March 2021

ETFs: Market Making and Trading Technology

With Linda Middleditch, Chief of Product Strategy and Engineering, Itiviti

Why are exchange-traded funds (ETFs) growing in popularity?

ETFs globally have gone through an incredible growth phase over the past decade. The market has increased more than 700%, from below $1 trillion to around $7.7 trillion now (with a predicted volume of over $10 trillion by 2025 according to the recent Ernst & Young Annual ETF Conference).

While historically ETFs have been seen as a cost-efficient way to track passive investments, more recently we’ve seen considerable growth in the active and smart-beta space, and these types of investment vehicles now accounting for around 30% of the global ETF market.

The technology needed to support ETF trading has advanced considerably in the last decade. In the past it was necessary to build in-house, but now it is possible to find good vendor solutions, meaning that the asset is accessible to more banks than it might have been previously.

What are the challenges around sourcing the composition of ETFs?

Historically, compositions needed to be sourced directly from the ETF issuers. Whilst now there are some good vendor solutions like Ultumus and IHS Markit, however the absolute requirement for accurate, timely compositions means market makers still face a challenge in ensuring they have the appropriate level of verification checks on their side (to guard against the large potential losses which can be quickly incurred due to incorrect compositions and prices). The response to this challenge has been that market makers often need to source from a mix of vendors and make sure they have quick identification techniques for disparities (as well as a back-up solution should that be necessary).

What are the key components required in ETF market making platforms? What are the challenges ETF market making technology needs to solve for?

The fundamental requirement for the market making platform is that it should allow you to create a strategy – based on your risk appetite – to enable you to manage a bid/ask level in the market. The challenge with ETFs is that individual markets in the composition can be closed, so it is necessary to have flexibility to proxy a price if there is not one available for a constituent. Flexibility and ability to manage this proxy logic can make a huge difference. This same proxy logic should be available in the hedging component to enable you to maintain your desired position.

ETF market making platforms should include the following distinct functionalities:

• Latency and throughput
• Effective composition management (including vendor comparison if required)
• Flexible pricing model ability to use substitute products or proxies when a market is closed
• Flexible hedging component incorporating both manual and automatic triggers
• FX hedging across all the major currency pairs
• Support for cross-asset trading

The ETF market is truly where all the asset classes collide, which is what makes it so interesting. ETFs are quietly changing technology and moving the sell side towards cross-asset technology and workflow flexibility.

Describe ETF creation/redemption workflows, and how is this evolving?

The creation/redemption workflow is a critical part of trading ETFs and has for years remained stuck in a very manual workflow. Historically, ‘Authorised Participants’ (APs) have had to fax the issuers to request the ETF creation / redemption, with subsequent workflows on (T+1) to book the resultant trades in the system. This time delay causes significant settlement risk, especially within the Delivery Versus Payment (DVP) method.

More recently there is a move towards more automation in this space, with the emergence of platforms like ICE ETF Hub and with the FIX Trading Community working on a standard FIX messaging for communicating with issuers. Not all ETF issuers are there yet, but this will soon be another electronified workflow that must be embedded fully in trading platforms.

Fixed Income ETFs have increased in popularity. What are the necessary platform changes to support this?

Global fixed income ETFs have seen a huge increase – $10bn net inflow in the YTD up to Sept 2020 – and that rise is expected to continue. This is a really interesting space for the technology providers and it is a focus for Itiviti. The Itiviti focus has been on creating a platform that combines the workflows and requirements of an equity-like product, with the underlying, more manual workflows of the constituent bonds.

There has been talk of electronification in bonds for some time, but now we are seeing the change in reality and we are positioning ourselves to support this new dynamic. Very exciting times are ahead, including finally the ability to support workflows within a single platform which brings significant cost benefits for the clients.

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Published by: MarketsMedia 27July2020

Peter Borstelmann, head of ICE ETF Hub, said the platform is aiming to expand coverage to international equity exchange-traded funds listed in the US and ETFs listed in Europe, Middle East and Africa.

Borstelmann told Markets Media: “We are looking to expand coverage to include international equity and EMEA-listed ETFs in response to market demand.”

The platform currently supports US-listed domestic equity and fixed income ETFs.

Intercontinental Exchange began talking to a wide range of ETF market participants two years ago. These conversations showed there was a need for transparent and consistent standards to simplify ETF creation and redemption trading.

“It is part of ICE’s DNA to leverage our strength in technology to bring innovative solutions to drive efficiencies and solve some of the markets’ most complex challenges,” said Borstelmann.

He joined ICE in 2014 as head of corporate development for the exchange’s clearinghouse for credit default swaps ICE Clear Credit, which increased clearing volumes of single name CDS instruments.

ETF creation and redemption

Creating and redeeming ETFs  requires the negotiation of large baskets of securities between issuers, authorized participants and market makers. However, each firm sends data in its own format and the need for manual copying and pasting leads to errors and the process taking much longer than it should.

“The existing process for custom negotiations is extremely manual with market participants using a combination of phone, email, chat or spreadsheets to agree to baskets,” said Borstelmann.

The ETF Hub streamlines this process through its centralized portal and FIX APIs, reduce the time and manual steps involved. FIX messaging is a standard for the financial industry.

Borstelmann explained that all the participants in the ecosystem will benefit from the transparency and scalability created by the ICE ETF Hub, which launched in October last year after being developed in less than a year.

“The order entry functionality was launched first last October, with our community members seeing turnaround time for orders being less than 10 seconds,” Borstelmann added.

He continued that Hub is an industry-wide, open architecture platform with standardized APIs that will allow external parties to establish connectivity as the ETF Hub community grows.

“With the passage of 6c-11, the US Securities and Exchange Commission has allowed a broader range of institutions to assemble baskets,” added Borstelmann. “The ETF Hub enables issuers to offer a solution in a more efficient and expeditious way.”

After launching the order functionality, ICE is allowing market participants to screen, communicate and assemble custom baskets with issuers electronically. The exchange launched a pilot program so market makers can experience the custom basket negotiation functionality in a live production environment. Several market makers, including Jane Street, Old Mission and CTC, have joined the program according to ICE and additional firms are expected to enrol in the coming months.

Growth areas

Last month both Credit Suisse and Wells Fargo joined the ICE ETF Hub as Authorized Participants, tanking the number of APs to seven.

Today ICE announced that JP Morgan Asset Management has joined the ICE ETF Hub advisory committee as a development partner for the platform.

Joanna Gallegos, global head of ETF strategy at J.P. Morgan Asset Management, said in a statement: “As an issuer serving fast-growing ETF markets, we’re aware of the critical need for a robust infrastructure for the primary market that can support our customers’ needs for both investment returns and innovation.”

ICE ETF Hub reported that it processed record notional volume of $148bn (€126bn) in the second quarter of this year, an increase of 9% from the first three months of 202.

Borstelmann highlighted that the two current hot areas of growth right are in fixed income and active non-transparent ETFs.

ICE is launching connectivity between ICE ETF Hub and ICE FI Select, enabling a trader involved in a custom basket request to send a bond or list of bonds to secondary market liquidity with a click of a button. ICE Select provides connectivity to the entire ICE fixed income ecosystem, including all the ICE Bonds execution platforms and ICE Data Services evaluated pricing and analytics.

ETF flows

ETFs and ETPs listed in US had net inflows of $189bn in the first half of this year, 63% higher than the $116bn net inflows gathered a year ago according to ETFGI, an independent research and consultancy firm. Assets of $4.3 trillion invested in ETFs/ETPs listed in US at the end of June are the third highest on record.

Fixed income ETFs/ETPs listed in US had net inflows of $83.6bn in the first half of this year, 28% more than the $65.5bn in net inflows in the first six months of 2019.

In comparison, equity ETFs/ETPs listed in US attracted lower net inflows of $39.9bn over the same time period, which was also less than the $41.43bn in net inflows for the corresponding period to June 2019.

ETFGI also reported that assets invested in actively managed ETFs/ETPs finished June at a new record of $182.7bn.

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