London Stock Exchange arrives at the debate on how the future of ETF trading will develop from a position of strength for smaller-sized executions. We have a long and distinguished history of matching buyers and sellers in small, and not so small sizes. The modern-day process is extremely efficient, as member firms can access central counterparty (CCP) clearing and straight-through processing with sophisticated, automated, low-cost trading systems. It is worth noting that alongside minimising counterparty risk, CCP clearing is now seen as a vital solution to manage the operational complexities that the impending Central Securities Depositories Regulation (CSDR) will require around settlement discipline. Returning to trading, at the most basic level, an exchange simply matches buyers and sellers. But have exchanges got it right for all types and sizes of ETF buyer and seller?
ETF Block Trading
As part of London Stock Exchange Group, Borsa Italiana is an example of a venue already operating a successful ETF request-for-quote (RFQ) model that trades large ETF orders on-exchange. In a single day in March, Borsa Italiana matched €160mm across 79 trades. The median RFQ trade size that day was €1.13mm. During Q1 2020, 8.2% of all ETF trading on Borsa Italiana was via RFQ. So, Borsa Italiana is proving that an exchange CCP-cleared RFQ protocol does work well when executing ETF block trades.
Building on the success of Borsa Italiana’s ETF RFQ model and leveraging London Stock Exchange Group’s ability to innovate in capital markets, we embarked on a journey to develop a new and improved ETF RFQ offering: RFQ 2.0. The new service, which we expect to be live in July, is focused on the end user and is designed to get outcomes that are as good as bilateral RFQ platforms, but which will on many occasions, deliver better execution. Importantly, we are designing it to suit the conditions-based execution techniques that more and more investors are utilising – all within a low-cost, centrally cleared environment, where the world’s leading liquidity providers and execution brokers meet to transact every day. It is an RFQ model with two distinct flavours:
- Sub-large-in-scale (Sub-LIS); and
- Large-in-scale (LIS).
With a view to merging low-cost automation with price improvement, London Stock Exchange’s RFQ 2.0 for ETFs will feature an orderbook sweep on our main market. This functionality is especially suited to a direct market access or an algorithmic trading style as institutional investors will likely accelerate efforts to channel ETF trading into an automated CSDR friendly process. With CSDR being implemented early next year, London Stock Exchange’s direct link to CCP clearing offers significant operational and cost benefits to market participants. In addition, the RFQ service is easy for investors to access as it behaves just like a new order type, with a single outbound message to the exchange.
Catalyst for Change
In the near term, we envisage ETF trading will adopt many of the characteristics of the equity trading landscape. For example, ETF algos are being deployed that will enable investors to place orders on-exchange that are tied to the adjusted theoretical value of the ETF. But it is fair to say that the choices for ETF execution have, until recently, been quite narrow. As a result, the launch of an RFQ system that sweeps the main orderbook has the potential to act as a catalyst for change.
The new RFQ functionality will enable larger ETF orders to be broken down into sub-LIS sizes, therefore benefiting from our sub-LIS auction model with an orderbook sweep. It will facilitate activity and give confidence to buyside clients who want to use ETF algos. For the first time, a distinctly separate, independent RFQ will be able to interact with that client’s agency algorithmic order resting on exchange. London Stock Exchange clients are already able to rest large-in-scale limit orders on our orderbook, in a hidden capacity, using the LIS waiver (>€1mm). They will now be able to do this with increased confidence and frequency, knowing that other traders who utilise ETF RFQ 2.0, especially in many high traffic ETFs, will witness RFQs trading against opposing hidden limit resting orders, with both sides benefiting from a saving in risk premium or spread.
Transaction Cost Analysis
Finally, a word on transaction cost analysis (TCA). In the same way that TCA has become the norm in equities, ETF traders will move away from the simple argument that by accepting the “best price” they are effectively fulfilling “best execution”. We believe the buyside will increasingly scrutinise the impact and reversion of ETF RFQ trades, in the same way as they would treat a portfolio trade. As a result, executing RFQ requests on London Stock Exchange’s orderbook will reduce market impact and allow for more precise TCA.
At London Stock Exchange, we are proud proponents of our orderbook integrity and of our market supervision capabilities. These principles ensure fair and orderly pricing, and trusted liquidity provision. This is especially valuable in times of heightened market volatility. By focusing on partnership and innovation, we look forward to helping the ETF ecosystem reduce the costly effects of fragmentation, efficiently manage obligations around settlement discipline and facilitate the search for true best execution.