National Bank desk on providing a vital service and why it expects the ETF industry to continue its rapid growth
Most of us like a good moan now and again. And for those in the investment business, it’s often the market makers that bear the brunt of people’s frustrations.
Whether it’s questioning liquidity or scrutinizing bid-offer spreads or products, as the epicentre of the trades, they are an easy target.
However, one of the leaders in the market-making field, National Bank Financial Group, believes that as time passes, and the benefits of what they do become apparent, advisors and clients will start to view them in a more positive light.
Roger Chandhok, director, global equity derivatives, told WP that market makers provide a vital service, giving investors liquidity and access to markets that would otherwise be tricky for them to trade in, like preferred shares, high-yield bonds and alternatives.
Advisors, typically, are highly price sensitive and sometimes critical but Chandhok said that once they are educated as to what market makers can actually give them, they understand the benefits.
“If they were to go out and buy or sell a basket of high-yield bonds or preferred shares, the pricing they're going to get on those types of instruments is not favourable at all. A lot of the time the ETF is priced more favourably than the underlying securities or the underlying baskets.
“It's all about education. Investors really need to understand what the market makers are actually giving them access to.”
Frederic Viger, managing director, head of institutional sales, ETFs, at National Bank, said confusion often occurs because many are more used to trading mutual funds. When a client sees a four-cent spread, they think there’s a NAV when it’s actually only struck at the end of the day when the stocks or the underlying securities close.
He explained: “The bids on the underlying basket will dictate what the fair value of the bid of the ETF is, and then the offers of the underlying will dictate what the fair value offer of the ETF is. The market makers will tag on any of the fees that they might be charged by the ETF or issuer and that price is basically the same price you would get at the end of the day.
“But people look at this and they’re like ‘the spread is too big’. But they don't understand that market makers are quoting it at fair value throughout the day, so that gives them the opportunity to pick their entry time as opposed to just getting a NAV on a mutual fund.”
While some believe market makers take too much of a cut on trades and accuse ETFs of creating volatility, Viger joked that there will always be haters. But with ETFs outselling mutual fund flows for two years straight, he sees only positives for the industry moving forward.
“They’re products you can trade all day and they're transparent,” he said. “They're very cheap and they’re getting cheaper, and we have more and more market makers quoting them, so the pricing is getting tighter and tighter.”
Competition among market makers is healthy for the industry and it’s set to intensify as the number of ETFs – currently approaching 850 – continues to rise. National Bank is ready for more products and more issuers, with many pundits expecting the ETF industry to double in size in the near future.
As early trend-setters, Viger is bullish about the bank’s ability to meet growing demand.
“We were the firm that pretty much started all this by being very aggressive, investing in technology and partnering with a lot of the different ETF issuers. We’ve brought more issuers to market than any of our competitors. We like to say we’re the go-to shop for ETFs.”
The role of the market maker is not a job that has changed a great deal over the years. At its heart, it remains about providing liquidity and a two-way market throughout the day. It has, though, got more complicated. Initially, it featured mostly index-based products before fixed income ETFs began to emerge. Now there are a host of different solutions in the market place, from factor-based strategies to emerging markets.
That’s meant a trading desk like National Bank adding more specialized staff to its roster in order to hedge the risk better.
Viger said that the net result is the business has become more of a team effort. What used to take two people, now requires a hockey-like squad with everyone performing different roles.
On top of that you need a robust trading and algorithm platform, which require strong programmers and I.T. developers. As technology has advanced, the “algo” factor and threat from high-frequency traders has also grown.
“When markets are moving very fast, you don't want other people picking you off,” Viger said. “At the end of the day, you're providing a service - you're in the market quoting bids and offers on 800 products. If you're trying to do this and you don't have a robust system, when markets are moving fast other people will pick you off, whether it’s high frequency traders or others that have faster or better systems. It’s never a good thing when market makers start colliding against each other!”
What happens, though, when the market crashes? What does a market maker do then, when all around them appears to be hitting the fan?
The simply answer is: the same as before – keep providing liquidity at the price it’s worth, while managing risk. This might include pricing half-a-penny or a penny outside the norm as a buffer for volatility but otherwise, Viger said, it doesn’t matter whether the market is down 5% or up 10%.
“Whether the market is down, big or not, our programs are running at the same spreads, assuming we get all the good data and everything. This week is a good example [when the US market was down 4%]; we have the same market share that we have always had and we're quoting 800 products in Canada. Market makers will always be in the market providing liquidity no matter what.”