The Imitation Game
By Simon Barriball, Head of ETP Trading in Europe for ITG
ETFs have been part of the global investment landscape for nearly three decades. Recent years have marked record growth in the asset class both in the UK and Europe. However, some stark differences remain. Despite assets under management (AUM) in the European market doubling since 2013, it is still less than a quarter of the size of the US market which stands at $3.63trn.
This is set to change, with commentators predicting that European ETF AUM could more than double in the next 3-5 years. The issue is that European markets may not be positioned to handle this increased inflow. This can be partly explained by the contrasts between European and US ETF trading.
Europe’s fragmented market stalling ETF lift off
One factor behind the US market’s leading status in ETF assets is higher retail participation, as this adds to the markets’ liquidity, but there are also notable differences within the foundations of European and US ETF trading that need to be taken into account.
Firstly, the US’s market structure is far simpler, with a single settlement depository and single settlement currency. The nature of European markets makes them far more complex with multiple country and currency listings of each ETF. This fragmented landscape plays a major part in the comparative lack of on exchange liquidity in Europe when compared to the US.
The higher levels of on exchange liquidity in the US can also be explained by its trading behaviour. US traders, on the other hand, are known to take a variety of approaches to trading ETFs, and around 70% of ETF trading executed on lit exchanges. In contrast, in Europe, the same percentage of the market is traded away from the primary exchanges typically via RFQ MTF platforms. This concentration is significant for a single asset class. While RFQ platforms can provide tremendous benefits, if we reach a scenario where they are the only tool traders use, it could be to the detriment of on-exchange ETF liquidity and execution outcomes.
It’s clear that something needs to evolve to improve both the market structure and trading approaches to give the EU market the tools to grow.
Greater tech adoption to pave the way forward
The revolution in Europe will likely be driven by new advances in technology from a multitude of sources. This could range from exchange RFQ platforms that interact with order books to smart order routers (SOR) and intelligent AI algorithms that are more ETF-aware and capable of interacting with all available liquidity to include the primary order book, SI quotes, RFQ platforms and exchange RFQ processes.
Such technological advances should enable European traders to approach the market with a greater variety of trading strategies, essentially through introducing more execution tools. Traders would also need better pre and post trade data to assess whether something is liquid and should be traded on exchange, via an ETF SOR or whether they should use a purely RFQ approach. They should be able to segment ETFs based on how liquid they are, as well as how liquid the underlying asset is.
The right foundations will see Europe reap the benefits of ETFs
The ideal scenario would see the European trading strategy evolve into a combination of algorithmic trading, ETF smart order routing and smarter RFQs as well as pre and post trade analytics tools to refine traders’ strategies. In order for the European ETF market to reach the same heights as the US, traders will need a combination of technological innovations, accommodative market rules and greater inter-jurisdictional alignment.
If Europe gets this right, traders will be well placed to reap the benefits of ETFs in the years to come.
Source: Simon Barriball, Head of ETP Trading in Europe for ITG
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