It has now been about a month since a computer error cost Knight Capital a reported $440M. This was the latest incident (Flash Crash, BATS IPO, and Facebook IPO) that called into question the current state of affairs of market structure in the United States. As one would expect, the stories were fast and furious. The system is broken! Machines are out of control! Regulators must act today!
While the erroneous trades in this situation mostly affected individual stocks, Knight’s status as the lead market maker (LMM) for over 400 exchange traded products raised questions about how an event like this could impact the ETF space. How important is a lead market maker compared to the other market participants that are trading a product? More importantly, if an active market participant suddenly disappears from the ecosystem – for example, due to a Lehman type event or a significant regulatory change – how could it impact ETF trading?
The truth is that there are actually multiple players in the ETF ecosystem –market makers (MMs), lead market makers (LMMs), designated liquidity providers (DLPs) and competitive liquidity providers (CLPs), to name a few. To help make sense of the alphabet soup that is an ETF’s trading lifeblood, I’ve created a handy visual below to explain who does what.
A couple of points I’d like to highlight – first, the terms AP and MM are often used interchangeably, as many firms serve in both capacities. This can cause confusion as to who is responsible for what within the ETF ecosystem, especially in a Flash Crash type of event. The simple answer is that if a firm is making markets in an ETF on an exchange, and then that same firm performs a creation at the end of the day to manage their inventory, it’s actually serving two distinct roles within the ecosystem.
Also, putting numbers to each of these groups is an inexact science considering the number of exchanges and sponsors. We estimate there are at least 100 firms who provide liquidity in ETFs in some capacity. Of these 100 firms, we estimate that there are approximately 20 who are registered as market makers at the exchange. Of these 20 firms who are registered on the exchange, approximately 10 of them act as an LMM/DLP/CLP in some capacity.
The role of the LMM (or DLP, or CLP) is an important one – particularly when an ETF first launches – but it’s not the “end all be all” of an ETF’s liquidity. While an LMM can play an important role in the early days of a new ETF’s trading, it becomes less important as a product becomes more liquid (more on this in a future post). In addition, ETFs trade on all exchanges thanks to another acronym known as UTP (unlisted trading privileges). And we often see that for our more liquid products, the listed exchange will not even account for more than a third of the total traded volume that day.
The bottom line is that having so many active firms in the ETF ecosystem can lead to liquid markets that trade in line with the fund’s intraday fair value. The competition between these firms – each of whom may have very different business models – gives investors options when it comes to getting the best execution as well as creating multiple trading “buffers” within the ecosystem.
Now that we have the definitions straight, my next post will dissect an ETF trade, showing examples of how these entities interact as well as giving some context around their different business models.