Monday, September 9, 2013

Illiquid ETFs and SEC Market Maker Incentives

By Tim Dulaney, PhD, FRM and Tim Husson, PhD

There is now nearly $1.5 trillion invested in exchange-traded products (ETPs) in some 1,400 exchange-traded funds and exchange-traded notes.  However, not all of that huge sum is distributed evenly.  Some funds, like SPY, have huge assets under management, while many others struggle to top $10 million.  Often, issuers will close lightly-traded ETPs (leading to substantial turnover each year), but if they don't, the market price of an ETP can often deviate from the net asset value of its holdings or otherwise price inaccurately.

To address this concern, the SEC recently approved a proposal that opened the door for an NYSE Arca Exchange Traded Product (ETP) Incentive Program "designed to encourage market makers to take [lead market maker] assignments in certain lower volume ETPs by offering an alternative fee structure [...] if the [lead market maker] meets or exceeds certain performance standards".1  Essentially, they will pay traders to make a markets in illiquid ETPs.

The program is meant to "enhance the market quality" for low volume ETPs by incentivizing market makers to take assignments for which making a market could be more challenging.  For the purposes of the rule, an ETP is considered "low volume" if the consolidated average daily volume is less than or equal to one million for the three months preceding entry and the ETP has not halted share creation or redemption.2

The program will alter the NYSE Arca's fees and charges for exchange services (PDF) to provide for "fixed quarterly payments, rather than variable enhanced transaction rates, in return for meeting their monthly [lead market maker] quoting obligations".  These additional payments will be funded by issuers of the ETPs on a voluntary basis and will run the issuer between $10,000 and $40,000 per annum.3

Although the optional incentive fee is meant to enhance the market for low volume ETPs, issuers are not eligible to receive a refund even if the lead market maker (LMM) does not meet the performance requirements -- for example: the LMM is required to maintain quotes or orders at or inside of the National Best Bid or Offer (NBBO).4  The participating LMM is paid only if the performance requirements are satisfied for a given month (1/3 of the incentive fee less a 5% NYSE Arca administrative fee).

In addition, some commentators are concerned that many potential market makers could be high-frequency traders, who could take advantage of the relative illiquidity of these products with no tangible benefit to investors.  We'll follow the implementation of the pilot program to see how many issuers participate and how the liquidity of their ETPs change as a result of their participation.
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The March 2012 SEC filing for the incentive program can be found here (PDF).
For an example of a halted share creation, see TVIX or AMJ.
This fee charged to the ETF issuer would be separate from the listing and annual fees.
4For more information on LMM requirements, see Section I(D).

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