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Reggie Browne: Not All ETFs Traded Equally

Olly Ludwig


Reggie Browne, perhaps the most influential ETF trading expert in the world, says investors are clearly starting to grasp the power of the ETF, but they are still assimilating all the nuances of ETF trade. That knowledge gap is more significant than meets the eye, as ETF trading these days can amount to as much as 40 percent of dollar-value trading volume on U.S. exchanges.

Moreover, as the financial world began to grasp three years ago when the “flash crash” whipsawed markets in a dramatic 30-minute period before the close, ETFs may trade in real time like stocks, but they’re different in important ways. On that day, after all, about two-thirds of all the securities with canceled trades were ETFs. That fact led regulators to get to work.

Browne, who declined to discuss the acquisition of his firm Knight Capital by high-frequency trading firm Getco, did tell IndexUniverse.com Managing Editor Olly Ludwig he believes that it would be foolhardy to say that another flash crash can’t happen. But he detailed some of the encouraging steps regulators have taken to ensure that the world of electronic trade remains stable even as it delivers the tight spreads and lower costs investors should be happy about.


IU.com: Are investors and advisors getting wiser to trading ETFs correctly? What is your biggest recommendation to them to get it right?

Browne: The industry is doing a good job educating investors, advisors and the media about how ETFs are structured while dispelling the considerable misinformation that some people have. Investors are increasingly coming to appreciate that ETFs offer greater transparency than mutual funds, with the added advantage they can be easily traded in real time.

But ETF execution is still not yet widely understood. Take the example of a request to trade $75 million of a midcap ETF such as the MDY (MDY) within 2 cents of the bid or ask. That narrow a spread is possible with a large-cap ETF such as SPY (SPY) with an exceedingly large secondary market volume, but such a spread is probably not realistic for a midcap ETF given the underlying liquidity of the stocks, related futures and notional value of the trade.

Investors need to understand that when they choose an ETF for asset class exposure, they need to be cognizant of the fundamental liquidity of the underlying basket and the impact of trade size.


IU.com:A lot of people talk about limit orders being the way to go to get the right execution. Is that your opinion too?

Browne: Limit orders are appropriate for individual investors who execute through the trading desks of retail brokerage firms. Larger orders generally require the expertise of a professional trading desk. Institutional investors and wealth managers with large orders can contact trading desks and market makers directly and determine alternative options to the displayed screen price.

The size of a trade can actually have an impact when you are trading ETFs in certain asset classes. Sometimes it can be more advantageous to simply have a trading desk create new ETFs rather than purchasing the ETF on the open market. Some ETF sponsors have the NAV of an ETF fund plus a preset spread, which is available only on creation-unit-sized orders. Limit orders may imply there is sufficient liquidity in the secondary market for the order to be executed.

IU.com:What's the downside to a limit order that some may be overlooking?

Browne: Limit order use requires that the investor monitor the order and the market for an execution. Markets are constantly moving, so refreshing or readjusting the limit may be required in order to receive an execution. There is little downside if the investor is attentive to the market. However, investors should note, in a volatile market they may miss the opportunity to trade at their intended price or they may end up paying a price compared to NAV.

IU.com:Do you buy that electronic, algorithmic markets are creating instability?

Browne: Since the electronic formats are still relatively new, the industry and regulators are still in the process of identifying risks and quickly addressing them with new regulations. With the adoption of Regulation NMS [Reg NMS], regulators have created exactly what they intended:a faster, easily accessible and more transparent market. This, in turn, has lowered trading costs and has been a major boon to investors.

IU.com:Is the “flash crash” of May 6, 2010, history, or could it happen again?

Browne: One would never be so bold as to predict that a flash crash could never happen again. Technology allows for great efficiencies and market improvements, but it would be dangerous to assume that the recent enhanced regulation in response to the flash crash can prevent another such event.

That said, regulators have taken some important measures to help prevent another such event. The most notable is the new limit up/down rule which acts as a circuit breaker for equities. The new limit-up/limit-down rule is designed to limit the short-term price volatility of a single security, and replaces the single-stock circuit breakers. Limit-up/limit-down price bands for each security will be set—and reset throughout the trading day—at a percentage above and below the security’s average price over the prior five minutes of trading. But it will not be reset if price movements within the period are 1 percent or less.

The price band for most stocks in the S'P 500 Index and the Russell 1000 Index, as well as certain exchange-traded funds and notes [Tier 1 NMS securities] is 5 percent. The price band for most other listed stocks and certain other exchange-traded instruments [Tier 2 NMS securities] will be 10 percent. Price bands will be doubled during opening and closing periods, and broader price bands will apply at all times for listed stocks and exchange-traded instruments priced at or below $3.00. If bid or offer quotations are at the far limit of the price band for more than 15 seconds, trading in that security will be subject to a five-minute trading pause.

Additionally, enhancements to the marketwide halt rules are expected to further refine the situations where marketwide halts occur that are tied to a broader index of securities rather than just the Dow 30.


IU.com:What do you make of the exchange proposals that create incentives for market makers?

Browne: Knight was an early proponent of this concept, and we believe that the program will serve a great benefit to the marketplace in the form of narrower spreads and increased liquidity.

Market makers and authorized participants are a key link in the delivery chain to the market of new ETFs. Knight commits a significant amount of capital to seed newly launched ETFs. Unfortunately, the number of well-capitalized, committed seeding market makers is shrinking, given the enhanced regulatory burdens.

Knight has emerged as leading market maker on nearly 35 percent of ETF listings on NYSE Arca. We are one of the few remaining firms still willing to commit capital to seed ETFs.

Well-established ETF issuers generally do not have problems getting their new ETFs seeded, but the upstart firms do. The number of new issuers at the various stages of entry seems to be growing by the day. But seed capital and market-maker support without enhancements to the ETF market structure will diminish given the abundance of growing demand with a limited field of participants on the sell side.

So, incentive proposals that strengthen market structure and inherently entice market makers to assume a higher degree of affirmative obligation merit backing from all participants. A large and competitive field of market makers is needed to foster innovation in the industry.

The incentive programs are intended to address not only seed capital and the IPO process, but thinly traded ETFs that only have one or two market makers quoting at the arbitrage bands or at the underlying basket. Successful ETFs generally have two stages of liquidity, retail orders inside the arbitrage bands; and professional liquidity providers at various degrees through the liquidity surface.

Thinly traded ETFs generally don’t have the benefit of a deep depth of book which is displayed, meaning it would be difficult to determine where you can trade $200 million of a thinly traded ETF. Our current market structure has created a vacuum in liquidity discovery. The proposed incentive programs target this issue.

IU.com:Is there any place in modern markets for old-school market makers who plied their trade on trading floors?

Browne: Machines can do things very fast and very efficiently, but they are limited when it comes to handling certain situations such as illiquidity or unusual market conditions. We believe that a hybrid approach is the best approach to deal with the situations that automation cannot handle.


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