In late 2019, the passing of the ETF rule (6c-11) in the U.S. added custom baskets and negotiated orders to the industry’s toolbox, regardless of when the issuer entered the ETF arena. With a little over a year now passed since the first issuers started to list under these new guidelines, the ETF industry is demonstrating rapid adoption of custom baskets.
The majority of ETFs in the U.S. use in-kind order settlement to manage subscriptions and redemptions. Operationally this is done by providing a list of securities (i.e., a basket) that the liquidity participant (i.e., Authorized Participant) delivers free of payment to the ETF in exchange for ETF shares as part of a creation, and vice versa for a redemption. Prior to the ETF rule, the majority of ETF issuers were required to use a basket that was a pro-rata slice of the fund’s holdings on the day the basket was constructed. As a result, any portfolio changes were managed by the portfolio manager outside of the ETF’s creation/redemption mechanism, thereby reducing the ETF’s ability to maximize tax efficiency, which the creation/redemption mechanism affords ETFs.1
For a refresh on what issuers need to contemplate in employing negotiated orders, see U.S. ETF Rule: Are You Ready for Custom Baskets?
Overall, more issuers and primary market participants are taking advantage. In fact, volumes jumped 100% between Q1 2019 and Q1 2021 (see Figure 1). However, while ETF issuers in the U.S. listed under the ETF rule have access to the tool, the percentage of orders that are negotiated vs the total volume of primary market trading remains small.2 Even more telling is that while volumes have increased dramatically, the number of ETF issuers using negotiated orders has increased only marginally at 3% YoY. In the first quarter of 2021, 25% of the ETF issuer community serviced by BNY Mellon used negotiations vs 22% in 2020.
Diving deeper into our analysis, fixed income portfolios continue to be the main benefactor of negotiations. In the 1st quarter of 2021, 92% of the activity was executed on fixed income portfolios (see Figure 2) followed by blended asset portfolios in a distant second with a 4% market share. Given the trends for Q1 2021 and what we have seen so far in Q2, it is not far-fetched that 2021 could see negotiated order volume grow 42% or more YoY vs 2020.
Based on data from 2020 and through the first quarter of 2021, there is some hesitancy. It is not due to the issuers’ product suite, but rather their comfort in making changes to their operating model to support negotiations at the same time managing the structural changes asset managers are undergoing outside of ETFs. From a direct standpoint, the issuer’s operating model and in-house technology capabilities to ease negotiations is critical. Without a clear policy and procedure backed by strong technology and their ecosystem partners, issuers are likely to be hesitant. Breaking down the use of negotiations is, at its core, building intraday baskets. Capital flow management for ETFs takes place predominantly through in-kind transactions using baskets. While a portfolio manager produces a basket the night prior that can be applied to any creation/redemption order, market conditions may change throughout a trading day requiring a portfolio manager and liquidity provider to agree on a new list of securities to be exchanged for ETF shares on that day.
Since the initial rule, BNY Mellon’s group of ETF specialists has had numerous conversations with ETF issuers and liquidity providers. It is clear that many issuers, while excited to use the tool, were in need of capabilities that allow for ease of negotiating the list of securities in a basket – for example, a list of bonds with an authorized participant (AP)or market maker that is in the best interest of shareholders and also attainable by the AP or market maker. That said, the data we have analyzed is promising that more issuers and liquidity providers are coming into their own with comfort in using custom baskets.
In considering how to utilize the negotiation tool, here are a few questions to consider.
For many ETF issuers, the implementation of policies and procedures alongside technology that is seamlessly integrated into their technology stack is daunting, particularly when considering that the investment management industry is undergoing a revolution in technology solutions. But given the benefits negotiations allow portfolio managers in terms of the potential operational and tax efficiency, now is the time to take negotiations head on.
1 May 2020. ETF.com. “Why are ETFs so tax efficient”; etf.com/etf-education-center/etf-basics/why-are-etfs-so-tax-efficient
2 Volumes for primary market trading are limited to activity facilitated through BNY Mellon ETF services
3 BNY Mellon internal data (2019 – Q1 2021)
4 Market share percentage determined based on the total volume of orders placed for the calendar year
5 BNY Mellon internal data (Q1 2021)
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