Euronext Amsterdam stock exchange © AFP via Getty Images

In Europe, exchange traded funds can appear a contradiction: funds that are listed on major stock exchanges, but seldom actually traded on them. Even now, the vast majority of ETF transactions on the continent take place over the counter — mainly on smaller platforms that are not directly accessible to retail investors. And not all market participants believe this is an optimal system.

According to ETFGI, a London-based consultancy, about 70 per cent of ETF trades in Europe are currently executed on so-called Request for Quote (RFQ) venues, or in other OTC transactions. By contrast, in the US the majority of ETFs are traded on-exchange.

To some, limiting on-exchange ETF trading in this way reduces the temptation to buy and sell too frequently, and incur extra costs.

“I’m not sure whether promoting trading ETFs directly via exchanges encourages positive self-directed investor behaviour,” argues Monika Dutt, director of Emea passive strategies research at Morningstar.

She points out that John Bogle, who founded Vanguard and championed the use of low-cost index funds, did not like ETFs. “He thought that the wrapper could potentially encourage unnecessary trading activity within the retail segment,” Dutt explains.

Even when retail investors’ trading decisions are right, dealing on-exchange in Europe may not be the best way to execute them.

James McManus, chief investment officer at Nutmeg — a UK platform that specialises in low-cost portfolios — points out that his company is able to trade OTC as an institutional investor, and therefore access better pricing.

“That’s part of the benefit we are bringing our clients — economies of scale in the way that we trade means they benefit from savings relative to the cost on the exchange as a retail investor,” he says. “So we offer retail investors an opportunity to access the institutional terms.”

McManus explains there are many ways to trade OTC, including via RFQ platforms, and that Nutmeg will pick the right strategy for the individual circumstance. “Clearly, a key benefit of going OTC is that the European market place is fragmented and liquidity is split across many stock exchanges in different locations,” he says. “That means, by using an OTC liquidity provider, you can benefit from their perspective of liquidity across European exchanges, rather than simply the liquidity available on one exchange alone.”

ETFs can hold Bitcoin but are not always exchange traded
ETFs can hold Bitcoin but are not always exchange traded © Chris McGrath/Getty Images

However, to others — such as Lida Eslami, head of exchange traded products business development at the London Stock Exchange Group — there are clear advantages to trading on-exchange.

“When trading off-exchange, market participants have to ask themselves if they’ve done adequate pre and post-trade analysis to understand if the broader market could have offered a better price,” she says. Another benefit of on-exchange trading is anonymity, which encourages real competition on pricing, Eslami adds.

ETP trading has grown as a percentage of total LSE orderbook turnover

In addition to that, on-exchange trading ensures the aggregation of liquidity from different providers and central clearing of trades, she says.

Stefan Kaba-Ferreiro, head of trading and managing partner at GHCO, an ETF market maker, agrees that on-exchange trading offers advantages. He says GHCO’s “mission” is to drive more and more price discovery to the exchanges.

70% Percentage of ETF trades in Europe executed off-exchange

“Shifting ETF trading away from request for quote (RFQ) platforms to exchanges will mean there’s a clearer picture of the true liquidity available,” Kaba-Ferreiro claims.

Even so, like McManus, he acknowledges that the situation in Europe poses particular challenges because trading is split across various exchanges without a consolidated “tape” of trades. He says there is also a lack of trust among brokers, who worry that they will not get liquidity on exchange.

“If you know the majority of the trading will not happen on exchange, as a market maker, why would you show your hand?” Kaba-Ferreiro asks.

Nonetheless, Kaba-Ferreiro and Eslami believe the European market is maturing. ETP trading accounted for a record 12.4 per cent of order book volume on the LSE last year, up from 8.7 per cent in 2019. Eslami says the exchange has maintained those levels.

“2020 was a very strong year for ETP trading turnover on exchange and we’ve sustained these volumes throughout 2021,” Eslami says. “In times of uncertainty, the market gravitated to on-exchange trading.”

Kaba-Ferreiro says he expects a move to on-exchange trading to continue as demand increases from self-directed retail investors.

“Younger generations are learning fast, taking control of their investments and embracing efficiency and low cost,” he observes. “They don’t want to have to call anyone to send an order, or wait to see the execution. They want direct access, transparency and instantaneous reporting. I definitely think you will see more volume come to exchange and spreads [buying and selling costs] will get tighter.”

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