Curatia Analysis for Tue, May 9, 2023

In Market-Structure Developments Supporting ETF Growth, Nasdaq Sees a Model for the SEC’s Stock-Trading Overhaul  Sponsored

Jason Dibble Co-Founder, Editor in Chief

A simple 2019 rule change opened the floodgates to ETF growth by easing the path to new fund launches. Since then, organic market-structure developments have nurtured a flourishing ETF ecosystem — a trend poised to continue as tweaks from tick-size reform to enhanced liquidity-risk management meet market trends like mutual-fund conversions.

That iterative approach offers a blueprint for the SEC’s proposed overhaul of US stock trading, Nasdaq Head of US Exchange-Traded Products Giang Bui explained at the Security Traders Association’s Washington, DC spring update.

Flourishing Ecosystem

By empowering ETF issuers to market new strategies while sidestepping long regulatory approval queues, the 2019 ETF Rule unlocked an age of unprecedented ETF growth just in time for the retail-trading boom.

That growth has proven resilient even amid recent market volatility, a trend senior experts from Nasdaq, Invesco, and Flow Traders dissected in a fireside discussion on ETFs at STA’s Washington, DC spring update in mid-April.

The US ETF landscape saw 91 new launches and $81B in inflows in Q1. Two-thirds of inflows went to fixed-income funds. Actively-managed ETFs also drew significant interest as lingering recession uncertainty prompted investors to embrace defensive strategies.

ETFs’ market influence has likewise expanded. While ETFs accounted for 32% of US equities trading in 2022, their share surged to 40% in March as the banking crisis stoked volatility.

At the same time, ETF proliferation in diverse categories from crypto to commodities has spawned robust competition for inflows. As a result, 57 ETFs liquidated in Q1 — a 200% YoY increase contributing to the overall health of the ETF ecosystem as liquidity pools in successful funds.

“Even as recent developments have lowered issuers’ barriers to entry, they’ve also raised the bar for success,” Invesco Global Head of ETF Capital Markets and panel moderator Eric Pollackov noted.

Organic market-structure developments have been instrumental in boosting ETFs’ influence, according to the panel participants. Nasdaq, for instance, has developed a robust framework of liquidity incentives for market makers in newly-launched and thinly-traded ETFs.

Investor education has similarly aided ETFs’ cause by working to dispel the notion that ETFs undermine liquidity in their underlying securities. In fact, for every $9 traded in US ETFs in Q1, only $1 resulted in trading activity in their underlying securities.

With ETFs demonstrating strong growth in bull and bear markets alike, panel participants agreed the future looks even brighter. Seven in 10 respondents to a PwC survey published in March said they thought global ETF assets would grow from nearly $10T now to $15T or more by mid-2027. Experts predict active and fixed-income ETFs will lead the charge. Mutual-fund conversions could also prove a significant source of ETF asset growth.

Stabilizing Reforms

Regulation figures to be key to determining ETFs’ growth arc. While previous reforms eased the path to ETF launches, current rule changes aim to ensure ETF markets’ stable functioning.

Many of the changes to stock-trading mechanics that rulemakers floated in their proposed overhaul of US stock trading would apply to ETFs in equal measure. Panelists highlighted the potential for tick-size reform, for example, to lower trading costs but also imperil liquidity if taken too far — a concern that’s prompted the industry to rally around half-penny tick increments.

“What we’ve seen based on our research is that too many ticks within the spread can lead to wider spreads, increased message traffic, less resting time of quotes,” Ms. Bui said.

“So that’s something we’re paying attention to. And as Nasdaq wrote in our comment letter, just adding one tick below a penny will be beneficial enough to support tick-constrained stocks. So a half-penny tick is probably a more reasonable way to go about it.”

Finding the sweet spot that lowers trading costs without impinging on liquidity in the case of tick-size reform could require trial and error, especially since that sweet spot likely differs from one security to the next.

Such quandaries have spurred many industry participants to stump for a more incremental approach to the overhaul, which features a plethora of proposed rule changes, than regulators have thus far pursued.

“How can we make sure we’re making adjustments without creating any impact to market quality, increased costs of technology and operations?” Ms. Bui asked. “It has to be incremental change made over time to help us continue to make our markets best in class.”

Other regulatory reforms meanwhile aim to ensure funds maintain sufficient liquidity to tolerate distressed market conditions – a strength of ETFs that could accelerate mutual-fund conversions.

Amendments to the SEC’s liquidity rule proposed in November would require mutual funds and most ETFs to keep at least 10% of net assets highly liquid. They would also mandate swing pricing and a hard daily closing time for mutual funds as well as more frequent and detailed disclosures around liquidity risk management.

Rulemaking Blueprint

Despite the importance of those reforms to ETF markets’ stable functioning, their rollouts are decoupled and could span years. That iterative approach, which lets regulators observe the impacts of each reform independently and adjust rules as needed, could serve as a blueprint for the SEC’s proposed US stock-trading overhaul, Nasdaq says.

“The markets no doubt have to evolve over time, and the regulation then has to evolve with it,” Nasdaq Head of Strategy for North American Trading Services Chuck Mack said at last month’s SIFMA Equity Market Structure Roundtable. “And ‘evolve’ is really the key word. Evolution is iterative over a long period of time. So we need to see that. We need to see evolution.”

Nowhere is organic market evolution more evident than in the conversion of mutual funds, the industry’s prevailing fund structure, to their more liquid heir apparent in ETFs.

While ETF assets stand at just a third of mutual-fund assets today, ETFs are accruing inflows at five times the rate of mutual funds, reflecting investors’ growing affinity for ETFs. Moreover, Bloomberg Senior ETF Analyst Eric Balchunas projected last year that issuers would convert $1T in mutual funds to ETFs over the next decade.

Several factors are conspiring to make that estimate look increasingly realistic, according to panel participants. Active fund managers are getting more comfortable with ETFs’ transparency. Organic market solutions including services to reduce conversion friction and efforts to educate portfolio managers on the mechanics of ETFs’ in-kind transfers are also encouraging conversions.

“ETFs have always been a game-changer for their liquidity and tax advantages,” Ms. Bui said following the discussion panel. “To make mutual-fund conversions worthwhile, though, both investors and PMs had to better understand ETF mechanics. As that happens, conversions are likely to accelerate. My prediction is we’ll surpass $1T in conversions over the next decade.”

The development of organic solutions from vendor services to education efforts that stress collaboration among market participants is yet another reason to embrace an iterative approach to regulatory reform.

"Thoughtful evolution of regulation in collaboration with industry has encouraged innovation and lowered barriers to entry for new participants in the ETF space,” Mr. Mack told us. “By following the same approach in implementing its US stock-trading overhaul, the SEC can use a healthy process for industry-regulator cooperation to create a healthy framework for competition going forward.”

That could help regulators do more with less – and build trust with industry along the way.