Increasing growth in the number of Exchange Traded Funds (ETFs) in the U.S. market continues to raise questions around the liquidity of ETFs. As part of these discussions, the marketplace remains focused on improving the market structure for ETFs.
Since the implementation of Limit Up- Limit Down rules, a new area of discussion has been raised around FINRA’s Rule 5250 (Payments for Market Making). In this blog we will provide background on what Rule 5250 does and the current discussions on its repeal specifically for ETFs.
Rule 5250 prevents the receipt of payment directly or indirectly from an issuer of a security that is acting as market maker. The rule was enacted as a means to prevent companies from using direct compensation to influence a FINRA member’s decision to quote or make a market in a security and, thereafter, the prices being quoted. ETFs while being “exchange” traded, are derived off the basket of securities that it holds. Given the exchange listing requirement, ETFs are held to the same market structure standard as single name equities (i.e. corporate stocks) resulting in Rule 5250 being applied.
In November 2017, FINRA requested commentary from the ETF community as to whether or not ETFs in the U.S. should be exempt from the rule, based on an ETFs Bid / Ask being derived from the price of its underlying holdings. The structure of an ETF provides the marketplace with transparent views into the ETF’s fair value at any given moment. With this information known, ETFs are less susceptible to improper valuations as a result of the arbitrage mechanism ETFs employ to suppress any premiums or discounts. As an open-ended product with the ability to create and redeem ETF shares based on market demand, the classic constraints of supply and demand on market prices is not as pervasive as in the case with a closed-end fund or single name equity. The latter having the constraint of a finite amount of shares being made available. Market participants such as ETF issuers, exchanges, and liquidity providers believe that Rule 5250 does not provide protection from an ETF being unfairly valued and instead is an added regulation impacting the cost to trade for smaller and typically newer ETFs. In fact, of the comment letters sent into FINRA, 72% of respondents1 were for an exemption being approved. FINRA is currently evaluating all comment letters received and will then determine what changes, if any, to explore.
In the second biggest ETF marketplace2, European ETF issues have been able to provide direct compensation to market makers in support of their products for years. While both the U.S. and European markets have ETFs listed on exchanges, the similarities stop there. The European market is vastly different from a market structure perspective than that of the U.S. In European markets, the listing standards are fragmented with ETFs being listed across 26 different exchanges in 22 countries, each with its own market structure. As a result, quoting and printing rules for payment is required due to a lack of natural incentives to complete in the marketplace across so many different venues.
Unlike Europe, Japan’s Tokyo Stock Exchange, which is similar to the U.S. from a market structure standpoint, has implemented a sponsor supplied ETF market making incentive program. Whilst it is new, it will be a better proxy for any potential success or failure if FINRA proceeds with proposal.
1 Source: BNY Mellon, FINRA. As of September 14, 2018.
2 Determined by AUM as of August 2018 using ETFGI.com ETF data
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