Gareth Myburgh, Director of ETF Product Development at Citi Securities Services, discusses some of the unique aspects of the European ETF market that new entrants should be aware of and provides insights on potential for ETF conversions happening in Europe.
What are some of the unique nuances to the European ETF ecosystem that US managers should be aware of before entering the market?
The biggest difference between the European and US ETF ecosystems is market structure. Compared to the US, which is relatively straightforward, the European market is extremely fragmented which presents operational and liquidity challenges.
In the US there are only a handful of inter-linked trading venues and a centralized clearinghouse. By contrast, Europe has over 20 unrelated exchanges and clearinghouses. This fragmentation is partly due to European investors’ historical preference to trade and settle ETFs in their local market, despite the ability to trade ETFs cross border, but also by regulation.
Furthermore, unlike the US where the majority of ETF trading is done via exchange, approximately 70% of the volume of the European ETF market is traded Over-the-counter [OTC], making it difficult for investors to monitor market liquidity through a single lens.
How does the European market structure create operations challenges and how do they address them?
The multiple exchanges create operational challenges because they are not inter-linked for settlement purposes. Instead they are connected to the local Central Securities Depository, which can create an impression of liquidity issues. This is why most ETF managers now use the International Central Securities Depository settlement model that allows the ability to settle an ETF centrally, regardless of the local exchange that it was traded on. In order to take advantage of this improved settlement model, a Common Depository is appointed which is another aspect that will be new for US Managers.
To compensate for the liquidity challenges caused by the OTC nature of the market, firms often use paid for contractual market makers, which is another unique aspect of European market. This means that managers will directly pay market makers to ensure that there is adequate depth of book and tight spreads for their products throughout the trading day, since large institutional orders are often not on exchange. This is in parallel to any exchange spread requirements and presence rules and is a competitive edge Issuers have over one another in terms of market coverage.
These challenges make it important to develop a comprehensive listing strategy when entering the market. This strategy helps managers to determine the exchanges for trading their ETFs and is typically driven by their target market. It can also help to mitigate any liquidity issues that can arise from ETFs being listed unnecessarily in too many markets. When developing a listing strategy, managers also need to understand the relevant local country rules around marketing and distribution in each target market and this often requires having a physical local presence.
Given the complexity and challenges that the European market structure presents, it’s important for non-European managers to partner with providers who can help navigate them through the nuances of the European ETF market.
What are the key components in successfully launching an ETF in Europe?
Beyond understanding the nuances of the marketplace, when drawing up their European plan managers should focus on the four “Ps” ― Product, Place, Promotion, and Price.
First, you start with what product you are looking to launch and determine your target market. This will drive the place or domicile of your ETF. To grow business, you’ll need to focus on promotion and engage a dedicated sales team, as well as a capital markets function and a fully engaged marketing presence. Finally, you need to ensure that you price your ETF strategically, keeping in mind the competitive landscape.
Looking at potential developments, in the US there’s an emerging trend of converting mutual funds to ETFs. Is this something that we can expect to happen in Europe?
There is precedent in Europe for an ETF conversion but it differs from what has happened in the US. In the US, managers have opted for a direct conversion approach, where existing mutual funds convert directly to ETFs. In Europe, we have only seen an indirect conversion approach, where a new ETF shell is established and then merged with an existing mutual fund into the new ETF structure. Practically speaking, the indirect approach is more akin to a fund merger than a conversion, which means that a newly created ETF cannot carry forward the legacy fund’s performance history. Still, while not the same as the US direct conversion model, the indirect conversion can help mangers launch ETFs with scale.
Do you think that we’ll see the direct ETF conversion come to Europe?
There’s definitely increased interest in the idea. However, there are some key regulatory and practical challenges that would need to be overcome. On the regulatory side, a key hurdle would be getting approval from the relevant local regulators. It’s unclear whether the regulators would approve a direct conversion, and it’s important to remember that it took the US regulators several years to get comfortable with the idea.
More practically, European funds tend to be widely distributed across multiple countries, and it’s not uncommon for the funds to have dozens of share classes, often in multiple currencies. The process of rationalizing this for an ETF model would be a considerable operational challenge.
So, for the foreseeable future the indirect conversion approach will remain the only option.
