ETF Trading: When Two Worlds Meet

As one of the first exchanges in Europe to launch an ETF segment 21 years ago, the success story of these products in the capital and investment market can be followed very well on SIX Swiss Exchange. They are not only used by institutional investors, but are also increasingly found in the custody accounts of private investors - thanks to convincing advantages: ETFs are cost-effective and offer easy access to large securities portfolios, this in a secure and highly regulated "fund shell", and they can be traded efficiently at any time due to liquid secondary markets. 

As the name "Exchange Traded Funds" suggests, ETFs are investment funds that are listed and tradable on an exchange. However, in practice they are often not traded on the stock exchange. There are several reasons for this. One of them is the fact that institutional investors often buy and sell ETF shares in large quantities. This is difficult to handle on the exchange in an order book with pre-trade transparency, especially in the case of ETFs with less liquid underlyings. In these products, larger volumes are often not available in the exchange order book, as the market maker must provide executable prices at all times. These firm prices are an attractive feature for investors, but it carries risks for the market maker, especially in the case of rapid market movements.

Whereas in the early years, larger trades were mostly settled OTC ("Over the Counter") by telephone, in the last 10 years this has shifted to electronic trading on RFQ platforms ("Request for Quote"). There, selected liquidity providers are asked to submit a buy or sell offer, which is exclusively available to the requestor. The best price bid is executed and the requesting party receives a confirmation that it has requested from several parties and has thus observed the "best execution" rules in its implementation. This process takes place with virtually no pre-trade transparency and little post-trade transparency.

With MIFID 2, these platforms for smaller trades became regulated MTFs, which has certainly improved post-trade transparency somewhat. This has led to a situation where not only large blocks are traded via RFQ procedures, but also smaller trades increasingly take place there. The reason for this is the automation of workflows - large and small deals can now be traded via the same electronic interface.

This outflow of transactions that are below the LIS threshold ("Large in Scale") is causing problems for the traditional exchanges. Applying the RFQ model to the exchange is not easy for several reasons. In most cases, exchanges do not have direct access to the buy-side (e.g. asset managers, pension funds) which, however, can use RFQ platforms directly as end customers. Furthermore, the universe of traded ETFs is determined by the issuers and is therefore smaller than the full range offered by RFQ platforms.

Nevertheless, trading on the exchange offers many advantages, especially in terms of transparency and settlement. While trading on MTFs involves bilateral settlement, which is often costly and error-prone, trading via an exchange system guarantees smooth settlement. In addition, Swiss exchange participants in particular predominantly have automated access to the Swiss stock exchange, which facilitates trading.

In order to increase ETF trading on the exchange, the idea of "ETF Quote on Demand" (QOD) has emerged. This is a new order book for trading ETFs and ETPs, which was developed in close cooperation with ETF market makers and important trading participants for this segment and launched at the end of 2020. QOD offers institutional investors the possibility to settle orders directly with the most important liquidity providers in Europe in a bidding process. This can be done both fully automated and manually. For manual settlement, the Swiss stock exchange provides its participants with a specially developed user interface.

QOD is much more than an ordinary request-for-quote service: By integrating it into the existing trading system, QOD enables seamless settlement via a central counterparty (CCP). On-exchange trading with trade reporting, clearing and settlement thus take place in a fully automated straight-through process. In addition, the unique trading service offers the possibility to interact with the existing order book (the Quote Driven Market, or QDM). The best price from the QOD service is compared with the prices provided in the order book. If a price improvement is possible, there may be partial or total executions in the QDM.

The execution quality is documented in an automatically generated report. This is made available to the trading participants after the execution and contains both proof that the best of all quoted prices was used for the trade and a snapshot of the QDM order book (for comparison purposes). The requestor will not be charged any execution costs by the exchange.

The new regulated service offers the same post-trade transparency as the existing order book trading. In addition, QOD offers the advantage that all data is stored on Swiss servers and does not end up abroad. With QOD, trading participants still have the option of placing a limited order in the existing order book or settling larger volumes without pre-trade transparency and thus minimised market impact.

With the successful launch of the QOD service, the Swiss stock exchange has ushered in a new era for its ETF segment. Greater transparency and increased awareness of trading ETFs enable the impressive growth to continue. Just a few months after its introduction, trading participants were already benefiting from the combination of classic order book trading with the new QOD service, thereby achieving measurable price improvements for their end clients. To date, over 90% of the trades from QOD are as good as or better than the EBBO (European Best Bid Offer). As important liquidity providers will join in the coming weeks and months, we expect the quality of the trades to increase even further.