ETF Trading: New trading tools have emerged, accelerating the growth of on-exchange execution

Ivan Gilmore, LSEG

Ivan Gilmore (pictured), Head of Securities Trading, London Stock Exchange, London Stock Exchange Group (LSEG) writes that stock exchanges have shown resilience through mixed times and looks forward to a golden age of ETFs that lies ahead…

ETF trading volumes in Europe hit a new record in 2020. This is not a big surprise to the ETF industry given the consistent multi-year inflows, coupled with the heightened market volatility witnessed last year. In fact, ETFs seemed to attract even more inflows and trading activity precisely because the product wrapper proved its worth at the height of that volatility.

From an exchange perspective, stock exchanges showed resilience throughout the volatility caused by the Covid-19 pandemic, and indeed saw a larger increase in trading activity over the entire year relative to the wider trading ecosystem. According to BlackRock, ETF volumes in Europe hit USD2.8 trillion in 2020, up 22 per cent on 2019, and ETF on-exchange activity grew by 46 per cent. It’s clear that investors and market makers are leveraging the transparency and resilience that central limit order books offer. Exchange-led pre-trade transparency is at the heart of well-functioning markets, especially so for ETFs where there is often less investor turnover than in, for example, single stocks.

Moreover, market makers rely on the multilateral nature and trading anonymity of central limit order books to calibrate and benchmark their pricing models and to trade effectively. Order books offer an extremely valuable tool that trading participants rely on, in part due to the complexity of modelling and trading such a wide variety of Exchange Traded Products (ETPs), and the fact that customers who trade directly with market makers are inactive much of the time. The direct to customer pulse can be less reliable than the consistent heartbeat of the order book.

ETP turnover on London Stock Exchange increased by 50 per cent annually in 2020. That strong momentum has continued into this year, as evidenced by average daily value traded (ADVT) in Q1 2021 growing by 12 per cent year-on-year to GBP736 million. There are signs that this trend of on-exchange ETP execution will continue to outpace trading growth elsewhere, as more and more brokers and end investors utilise new execution tools to obtain, and importantly to better understand and evidence, best execution.

Investment banks are working on recently developed ETF algos, which are engineered with an ETFs intraday adjusted theoretical value in mind. These theoretical values are what the market making parts of the business work tirelessly to model, and of course, each market maker’s value will be subtly different. This is similar to the concept of equity algorithms navigating that landscape, trying to trade around an intra-spread “fair value” for an equity that is often somewhere between the bid and the offer. Market participants will point out that there are also premiums and discounts to navigate with ETFs and indeed the algos are being built to understand these. But for investors who want to trade immediately and who therefore are content trading at current observable prices, navigating these premiums or discounts is often less of an immediate concern than finding high quality liquidity in an efficient and automated way.

Let’s look at a recent example of how efficiently ETFs have been traded on exchange. In early March 2021, an equity emerging markets UCITS ETF traded over USD570 million in a four-day period on London Stock Exchange’s order book. On one of those days it traded approximately USD170 million. The average time-weighted spread between the bid and the offer over the entire 4-day period was under six basis points. This is quite an achievement for an emerging markets ETF. Considering the evidence of this tight spread alongside the fact that the average daily value traded was over 100 times the ETFs ADVT for 2020, one can see that using the order book provided an efficient way of accessing high quality liquidity in that ETF. The open-ended nature of the ETF wrapper allows market makers to continuously offer liquidity knowing they can “create” new ETF shares.

In addition to the uptake of ETF algos, which benefit from on-exchange pre-trade transparency, we are also witnessing a new form of on-exchange trading emerging. London Stock Exchange has been at the forefront of the development of a new innovative order type, the request-for-quote (RFQ) order type. This is a fully automated workflow and brings all the benefits of RFQ trading into a central limit order book world, including central counterparty clearing. It provides access to both lit and hidden liquidity alongside liquidity from RFQ market makers in one single atomic trading event. Launched in 2020, RFQ 2.0 is seeing over USD5 million of trading daily across several hundred ETPs, and as more RFQ requestors and responders adopt the new order type, we expect volumes to continue to grow. With the ability to get a full fill every time, most often inside the visible order book spread, RFQ 2.0 provides an attractive alternative to bilateral execution which is detached from the heartbeat of the order book.

It is also worth noting that with the Central Securities Depositaries Regulation (CSDR) on the horizon, we believe that more and more volumes will move to a CSDR friendly environment. Just under 90 per cent of ETP trading so far this year on London Stock Exchange has been in ETPs impacted by the impending CSDR. Despite CSDR not applying to UK settlement infrastructure, it will still apply to settlement for most ETP trading (by value) in the UK, and of course in the EU, as most ETP issuers have adopted an international settlement model known by the mnemonic ICSD.

At London Stock Exchange, we continue to believe that trading members and investors will increasingly want to adopt these new innovations, enabled by the same on-exchange execution experts that have developed a plethora of execution techniques and equity algos over the past 20 years. We believe the next few years can be a golden age for highly efficient ETF execution at a time when investors are increasingly utilising the ETF wrapper in their investment portfolios.

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