TECH TUESDAY is a weekly content series covering all aspects of capital markets technology. TECH TUESDAY is produced in collaboration with Nasdaq.
Last week’s Security Traders Association (STA) Market Structure Conference was entitled The Next Era, as it explored the ongoing changes and key questions that will define the industry’s future.
That forward lean filtered down to individual panels, including “The ETF Perspective” on October 11.
The panel introduction noted there is about $7 trillion in exchange-traded funds (ETFs) under management in the U.S., and the market’s emergence in the 1990s and rapid expansion over the past decade has had an enormous impact on market structure, first in equities and, more recently, in fixed income, and equity derivatives.
Panelists noted a primary factor for ETFs capturing market share from traditional mutual funds is superior technology, which provides advantages such as more transparency, intraday tradability and better access for investors. ETFs have pushed aside the old “three-year rule,” where a financial advisor would assess the suitability of a mutual fund over time based on quarterly data; with an ETF, that information is available effectively in real time.
The overall rise of ETFs is a well-told story, which has its roots in traders looking for efficient ways to buy into an index such as the Nasdaq-100 Index (NDX). But STA panelists cited two newer trends that will take the market into the next era: actively managed ETFs and the institutional adoption of ETFs.
Giang Bui, Head of U.S. Equities & ETPs at Nasdaq, said regulatory changes have paved the way for active ETFs, which now capture about 25% of ETF flows but still comprise just 6% of the ETF market.
The adoption of ETFs beyond broad-based passive funds has opened doors for a lot of new products,” Bui said. “Fund companies are seeing ETFs as a growth engine.”
Pension funds and other institutional asset owners weren’t involved much with ETFs a decade ago, but that’s changed over the past few years. “Especially since 2020, institutional investors are becoming more familiar and more comfortable with the ETF wrapper, and they are increasing their allocation to ETFs,” Bui emphasized.
As the number of ETFs proliferate, competition increases for ETF providers to differentiate and gather assets. That’s where intermediaries such as brokers and execution venues can add value.
“We’re invested in promoting market quality and liquidity, particularly for new launches,” Bui said. “We want to incentivize market makers and develop liquidity programs so these launches can thrive and get best execution.”
Panelists cited two pending regulatory items that may impact ETF markets as soon as next year.
One is the U.S. Securities and Exchange Commission’s (SEC) proposal to adopt variable minimum pricing increments, or tick sizes, for the quoting and trading of NMS stocks. Bui said this could result in “a majority of ETFs trading with too many ticks, which impacts market quality,” in the form of shallower depth of book, wider bid-ask spreads and higher trading costs.
The second concern is the SEC’s rule to shorten settlement times for equities trades to one day, which is meant to go into effect in May 2024. T+1 could create settlement timing mismatch between ETF shares and its underlying holdings, which would potentially increase costs and reduce liquidity in ETF trading.
New regulations notwithstanding, panelists expect the ETF market to continue to grow. Inflows have totaled about $330 billion year to date – a strong number amid often difficult market conditions – as investors across segments have embraced the investment vehicle and the ease of market/liquidity access it provides.
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