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Published in Automated Trader Magazine Issue 31 Q4 2013

Regulation can dramatically change trading conventions and market structure. One example of this in the ETF market is the Volcker Rule within the Dodd-Frank Wall Street Reform and Consumer Protection Act. This has fractured the ETF market making it hard for traditional buyside investors to tap the ETF liquidity they need on a request for quote (RFQ) basis. Fortunately, as Gary Stone - Chief Strategy Officer Bloomberg Tradebook - explains, there is now a solution.

Gary Stone

Gary Stone

Occasionally, two seemingly unrelated events collide to cause a real and very fundamental market issue. A classic example of this has been the combination of the Volcker Rule within Dodd-Frank and the way in which institutional investors have started to use ETFs.

Major outcome

The Volcker Rule's curtailment of speculative trading activity by banks has resulted in many market making, risk arbitrage and approved participant desks being moved out of banks and broker dealers into hedge fund buyside entities. However, for regulatory reasons, these entities cannot deal directly with each other or buyside institutional investors, such as pension, mutual and other hedge funds.

In isolation, this would be a business issue for just the new ex-bank/dealer buyside entities, but the fact that institutional investors have become far more sophisticated in the way they use ETFs turns it into a much bigger issue. These institutional investors are now using ETFs in three distinct ways:

• To gain strategic long-term exposure to a sector or an asset class through an equity-traded product

• To gain passive exposure as part of their core/satellite portfolio models

• As a tactical portfolio adjustment function that employs ETFs to track their benchmark as a vehicle, in order to gain immediate exposure on their fund inflows.

The snag is that this extensive use of ETFs by institutional investors is driving demand for much larger ETF blocks - at just the time when these investors cannot deal directly with those best qualified (the new buyside ex-bank/dealer entities) to respond to their demands.

This is a major issue, because ETFs have a number of unique characteristics that make them a particularly attractive tool for institutional investors. Although they trade like single stocks on exchanges and in dark pools, they have deeper liquidity profiles and narrower spreads than stocks of similar average daily volumes (ADV). Unlike single stocks, however, float can be created virtually "on demand" through the primary market, because approved participants can buy (sell) the ETF basket and receive (deliver) the ETF directly from the issuer.

Demand and supply issues

A further consideration is that most institutional investors have mandate restrictions which prohibit them from trading alternative instruments such as single stock futures, so their choices are therefore limited to cash stocks or ETFs. This is clearly reflected in the numbers. A recent Greenwich Associates report ("Institutional Investors' Relationship with ETFs Deepens", Q2 2013) revealed that 18% of institutional funds now employ ETFs in their portfolios, compared with 14% in 2012. Furthermore, the largest and most sophisticated investors tend to be the heaviest ETF users. For instance, nearly 25% of corporate and public pension funds with more than USD5bn in assets under management use ETFs, as do 47% of US endowments.

Greenwich's research also highlighted the fact that institutional investors are also likely to expand their use of ETFs, with nine out of 10 existing ETF users anticipating that their level of ETF investment would remain stable or grow in the coming year. Half of institutional users intended to increase their ETF allocations by 2014.

Figure 1
Figure 1
Figure 2
Figure 2

Both this anticipated rise and current ETF activity are something that the secondary market simply cannot satisfy efficiently. In a previous issue of Automated Trader (see "ETFs: A Growing Appetite All Around", Gary Stone, Automated Trader Q3 2013) it was explained that traders cannot simply rely on the "on-screen" or secondary market volume. Even as the sheer number of ETFs and the amount of assets under management have dramatically increased over the past few years, ETF turnover on the exchanges and dark pools (secondary markets) has stagnated. Traders executing institutional-sized orders need to tap both the primary and secondary markets as part of an overall liquidity-capture strategy.

The problem is that more and more of the counterparties in the primary market that could satisfy this institutional demand are now inaccessible. Or rather, they were.

Reconnecting the community...

Bloomberg Tradebook is reconnecting these previously divorced counterparties by creating an ETF request-for-quote (RFQ) platform that acts as conduit between market participants who for regulatory reasons can no longer deal directly with one another. The goal of the platform is to enable participants to meet in a fair, neutral marketplace where both the buyer and seller are happy to have traded with each other. Market participants looking for block liquidity can anonymously solicit, on demand, two-sided quotes from the network of liquidity providers.

To initiate a request for quote, users can click on the "RFQ" button on the bottom of the ETF single-security (BMQ ) montage (see Figure 1, #1) . Traders are prompted for their quantity (see Figure 1, #2) . The RFQ is sent to a diverse set of market makers who return two-sided quotes (see Figure 1, #3) . The trader can then either decline or accept the bid or offer to consummate the trade.

The execution strategies that traders are familiar and comfortable with when they execute large single-stock orders are applicable to ETFs. In many instances, when executing a large order, traders may first look for blocks and then manage the balance of the order using an algorithm; others may start the order with an algorithm and look for blocks at perceived "inflection" points to seek an overall better execution price. Traders can use analytics like Bloomberg Tradebook's Strategy Analyzer (STAZ) to seek statistics-based guidance on the selection of an appropriate algorithm and identification of potential price inflection points at which it would be appropriate to buy (sell) blocks.

...and grabbing some alpha

Where institutional investors are using ETFs as a tactical portfolio adjustment tool to track their benchmark while managing their fund inflows, there is the further opportunity to build a sophisticated (and ultimately automated) workflow that incorporates an alpha opportunity.

Take the case of a cash inflow into a fund - rather than try and trade a basket of cash assets in a hurry (inefficiently), investors may put the cash to work immediately by buying an ETF to get immediate exposure to their benchmark. Then, look to trade out of the ETF overtime into a desired underlying asset. On the one hand that could be termed an asset reallocation, but practically the implementation of selling the ETF for the underlying asset is essentially a pairs trade. As such, it presents a relative value opportunity to sell out of the ETF rich and buy into the underlying asset(s) cheap.

This can be readily achieved by linking the Strategy Analyzer with Tradebook's PAIRfunctionality (see Figure 2) or the pairs tools in the Bloomberg Professional Service. The Strategy Analyzer will identify the inflection points between the primary and secondary ETF market so the institutional investor can always be certain of unwinding the ETF leg in the optimal (in this case the richest) market. At the same time, they can use the Tradebook or Bloomberg Professional pairs functionality to pick the ideal points at which to execute the ETF and cash legs of the trade (when the ETF on the primary/secondary market is rich and/or the cash market is cheap).This isn't limited to just simple situations either. It is possible to trade up to ten assets versus an ETF using the Tradebook pairs functionality, which in addition to enabling the use of custom index formulas can also potentially amount to a substantial price improvement.


The sheer demand for ETFs from institutional investors, coupled with these investors' post-regulatory disconnect from primary market providers had the potential to become both a major bottleneck and performance issue for them. Tradebook's RFQ platform effectively reconnects this fractured trading community to enable the efficient sourcing of ETF liquidity at a mutually acceptable price. In doing so, it automates the voice process with straight-through processing and improved transparency, and also represents the first step in bringing efficiencies and automation to the ETF market.

That in itself is obviously valuable, but coupling Tradebook's RFQ functionality with its pairs capabilities will build out a complete automated workflow that delivers a further edge for institutional investors using ETFs to manage inflows efficiently while tracking their benchmarks. Whether one chooses to call the outcome of this a relative value profit or positive slippage - the beneficial end result is the same for the investor in terms of dollars.

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