Poor volumes see ETF market-makers get tactical

ETF market-makers recognise they will need to be both tactical and opportunistic if their businesses are to survive and defy investor lethargy over Asia-listed exchange-traded funds.

With bank funding costs rising and the trading value of Asia-listed ETFs dwindling (down 20-30% over the past year), market-makers acknowledge they will have to find a niche in Asia’s heavily brokered markets.

ETF trading volume in Asia is either skewed towards Korea or to products listed in the US. Korea claims about a third of the region’s total ETF trading volume, which for on-exchange trading averages $1-1.5 billion per day.

That stands in contrast to ETF markets in the US (on-exchange) and Europe (over-the-counter), which are 10 times the size of Asia’s by AUM.

The head of delta-one trading at a bank in Hong Kong says the profit margin for ETF business in Hong Kong and Singapore has shrunk to 1%, from 10% before the financial crisis.

Pre-2008, market-makers could pocket lucrative sums by creating units for BlackRock’s iShares FTSSE A50. Until recently that was Asia’s most heavily traded ETF but was unseated by the Shanghai-listed Huatai-Pinebridge CSI 300 ETF, which launched in May.

Marco Montanari, head of db X-trackers Asia – the biggest ETF manager by number of funds in both Hong Kong and Singapore, says market-making is generally viewed as a service which helps to increase the AUM of ETFs.

At present db X-trackers has 30 ETFs listed in Hong Kong and 47 in Singapore. Yet low profitability from decreased trading volume is proving a challenge for ETF market-makers.

Matthew Perry, co-head of execution services Asia at Société Générale, says his team has been operating a “price giver/taker model” in Europe for a long time, but in Asia he describes ETF market-making as a limited business given the market’s size and relative inactivity.

“We have an agnostic approach over our ETF pricing and who we make prices for,” says Perry. “SG is also participating dealer for a number of issuers, and our relationship with the core three to four external market-makers in Asia means we could be very competitive in pricing.

“We could make a price from our internal market-making desk, or from other market-makers if their bid/ask is lower than those quoted by our own desk.”

The head of delta-one says that while there are opportunities for ETF market-makers in Asia – particularly in Hong Kong as more A-share ETFs are listed under the expanding RQFII programme – he expects a number of ETF managers and market-makers to diminish.

“I don’t think ETF is a viable asset class for Asia,” he admits. “It is still dominated by retail investors who are stock-pickers and care less about diversifying their investments.”

He also points to high funding costs, which for banks buying listed equities stands at around 2-3%. “If you can’t get them off your books the funding costs would eat you alive,” he notes.

Market-makers need to provide continuous bid/ask quotes on an exchange to ensure availability of prices and liquidity. If they were to fund $500 million worth of inventory ready to provide bid/ask quotes on all 475 ETFs in Asia, that could rack up to $10 million a year in funding costs.

To stay viable, market-makers will need to be increasingly selective on which managers or products they work with, says the delta-one head.

“As you have to provide quotes constantly on screen, consuming set-up time and resources, you need to be opportunistic, focus on making money over the short term and ask, ‘what is investors’ flavour of the week?’ and trade around on these listings rather than spreading resources too thin.

“Around new launches we would steer clear from issuers that do not have marketing experience or products that have more obscure underlyings.”

Asia contributed 54 ETF launches in the first half of this year out of 342 globally, according to BlackRock data.

But with a view on the region’s potential, Montanari notes that 20 asset managers entered Asia’s ETF market and launched new products in the first half, compared with just two in both the US and Europe, respectively.