With 17 years of experience trading exchange-traded funds,
Reggie Browne is one of the most authoritative voices in the
world of ETF market-making. Browne's firm, Knight Equity Markets,
executes 136 million shares worth of trades each day, making it
one of the largest ETF traders in the country.
IndexUniverse.com Managing Editor Olly Ludwig and
IndexUniverse.com Correspondent Alex Ulam caught up recently with
Browne-the managing director of Knight's ETF team-for a telephone
visit to discuss the opportunities and challenges facing ETF
market makers in a world of high-volume electronic trading.
What gives you your competitive edge?
One of the competitive advantages is the fact that we deal with 720
broker-dealers. We have the majority of the flow.
Do you have some technological edge too?
We're really a tech firm, so everything here is homegrown and built
internally; nothing is off the shelf, so our costs are low in
comparison to our competition. Also, when we bought the Kellogg
Capital Group two years ago, that deal launched Knight on the New
York Stock Exchange and made us a lead market maker for ETFs. And
we took that unit from 30 people down to five. That gives you an
idea of the cost efficiencies associated with technology.
A lot of people talk about market-structure problems. How do you
see the big picture now that the market makers who used to rule the
roost on the floor at the Big Board are pretty much artifacts?
These days, there has to be a test of who's a market maker, and
there needs to be a better relationship between providers of
liquidity and the high-frequency guys who are just quoting to get
rebates from exchanges. And there should also be some
So for example, there should be a best-price obligation. A true
market maker should publish two-sided quotes with various depth
levels. So, not just top-of-the-book, but also quotes down three or
four levels to provide ample liquidity to prevent a "flash crash."
The flash crash really happened because people turned off their
machines and walked away. No one was accountable to maintain a fair
and orderly marketplace.
You're talking about going beyond Reg NMS (regulation national
That's correct. There should be a best-price obligation, there
should be a mass-quoted spread obligation and there should be some
sort of price bands around last sales. Also, there should be a
minimum stock requirement. And finally, there should be a higher
What are some of the key challenges regarding new ETFs coming on
the market in terms of establishing liquidity?
If you look at the ecosystem of ETFs, market makers historically
rest at the arbitrage band. Wherever the arbitrage is located,
market makers will begin quoting at that band. And the further you
go through this band, the more liquidity shows up. That's
fundamental. There's no disagreement about that.
But what's missing with new ETFs is that you have the market
makers quoting inside the arbitrage band; what's missing is the
retail flow inside the arbitrage band, keeping the appearance that
ETFs are liquid and tight.
So what are some of the challenging asset classes for pricing?
Fixed income, no doubt. Commodities, for example, also get
challenging because of the way that they are structured.
The complexities of the underlying assets are not well
understood by all market makers. Let's say you wanted to trade
Asian equities. In many of those markets, you have a transaction
tax. And you have boundaries around liquidity of foreign exchange.
So if you're trying to move a large notational trade, you have
different components of liquidity.
You have the liquidity of underlying equities that the ETFs are
associated with and you have FX liquidity-not everyone takes that
So that could be challenging for some of these emerging market
Emerging market ETFs, fixed income, commodities-they all have these
characteristics. I have customers all the time saying I won't pay
more than a penny over the quoted offer in the markets for any
notional size. And it's such a misnomer because you have liquidity
or impact restraints.
What do you think about this new Nasdaq program to incentivize
market makers? Are these fees of $50,000 to $100,000 really enough
to establish an ETF?
I'm semi-lukewarm to it. First, there are 875 ETFs in registration.
If they were all to come out, you'd need about $4.5 billion of seed
capital to launch those ETFs. Because ETFs are launched by market
makers, you need the market-making community to provide that seed
In some ETFs-let's say, for example, if you're trying to launch
a U.S. ETF with Greek sovereign debt inside of it, or Spanish bonds
inside of it-there is inherent risk of the ability to hedge that
asset class. And if that ETF is not totally fungible with a hedge,
there's market risk associated with launching those ETFs.
Is it getting harder to launch new ETFs?
Well, with incentive programs like the one the New York Stock
Exchange is proposing, that process will be a lot easier, because
market makers will now get compensated for the seed capital they
put up. And then, because there is a model in place, they'll be
forced to provide better markets for the end-customer.
So here's an example. When BATS launched its program where they
put five market makers in competition in trying to get $200 a day,
a payment that is annualized at $50,000 a year-the effective
spreads went from 40 basis points on Arca down to 22 on BATS. So
the net winner has been the retail public, because now they're
getting tighter spreads to trade on new ETFs.
In the Nasdaq and NYSE proposal, ETF issuers would make payments to
market makers. What's your opinion about that, since historically
they've been prohibited from doing so?
It's been on the books that fund companies can't make payments to
market makers so that there isn't an appearance of natural ceilings
and floors around securities. That stems from small-cap stocks. But
because ETFs are derivatives, you don't really have those
I suspect that the New York Stock Exchange's proposal will be
approved, maybe with some slight modifications.
The Kauffman Foundation got attention for its assertion that ETF
trading is having a deleterious impact on IPOs. What is your
How is that possible? How can ETF trading prevent a company from
becoming public? I think the biggest hurdle has been government
intervention with Sarbanes-Oxley-that's the IPO problem.
What about the impact of hedge funds on ETF trading; are they
artificially fueling market volatility?
I don't think so. All asset classes have had a higher correlation
to one another because of heightened volatility in the marketplace.
When people are dumping assets, they're dumping all assets, and so
the correlations go higher across the board. So I don't think ETFs
are necessarily the root cause of it.
What's the best approach to buying lightly traded ETF's? With these
commodity ETFs, are there certain times of the day that are best to
We advocate trading windows, when it's best to trade certain asset
classes. And basically it largely stems around when liquidity is
the deepest in the asset class. For example, you're not going to
trade the coffee ETN ticker (NYSEArca:JO) past 2:30 p.m. Eastern,
because the futures have closed at 2:30. So the optimum time to
trade that is around noon, when a lot of people are making markets
in coffee futures. So I think that's just an example of what we
advocate to our client base. And for some ETFs that are thin in
terms of average daily volume in the secondary market, you can
still trade-but you want to pick your price as a limit order.
What does the whole playing field look like to you as you survey it
and imagine what things might be like five years from now?
Well I think the last five years have been dominated by investment
advisors deploying models using ETFs and hedge fund for hedging
purposes. They're going to always remain there, but I think the
pie's going to grow with more users.
We'll see institutions firing active managers and going the
passive route, and ETFs will be their vehicle of choice. I think
that you'll see a longer buy/hold strategy deployed using ETFs in
comparison to being held for five minutes.
Have you taken measure of this new ETF trade group-National ETF
Association (NETFA)-that John Hyland at United States Commodity
Funds and a couple of other people put together? Conspicuously, it
doesn't include the Big Three-iShares, State Street and Vanguard.
Do you think it's a good first step, or do you think it's doomed to
fail because those three huge players aren't yet part of it?
This is probably the fourth attempt of some sort of initial group.
Without all the participants agreeing on a format and
participating, you're not going to have one central voice from an
issuer point of view, and the industry needs its own voice. So
without Vanguard, State Street or iShares involved in this
particular venture, I don't know about its long-term prospects.
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