Part II – Electronic Execution
By J. Kolman Estreicher, Wolverine Execution Services (WEX)
Intended for Institutional Investors.
Some of the biggest misconceptions with respect to ETF trading seem to originate from the electronic marketplace. These misconceptions typically involve casual sentiments toward placing ETF market orders; frustration resulting from an ETF’s screen liquidity relative to total transaction size; and the optics associated with average daily volume (ADV), which could eliminate an ETF from portfolio consideration.
In the first installment of Tales from the Tape, we reviewed how the electronic marketplace can be an extraordinarily convenient execution venue, particularly if transaction sizes are small and the ETF has a high ADV with a considerable amount of Level 1 and Level 2 screen liquidity. However, there are more than 1,400 exchange traded products in the US alone, and only a small subset meets these criteria.
For ETFs with a lesser degree of screen liquidity, a large market order could potentially affect the price of the ETF by several percentage points. If the price of the ETF moved before your order fully executed, what would you do? If the ETF continued trading at an unfavorable level and did not recover, when would you execute again, how much would you be able to execute, and what price would you receive? Sure, limit orders can help avoid such dire circumstances; however, they don’t do much to prevent partial fills. If you decided to post a larger limit order, market makers could (A) go on the offensive by using your order as a benchmark to re-price their quotes or (B) adopt a more defensive posture by fading their markets to protect themselves from an anticipated “iceberg order.”
These are some of the reasons why market makers rarely post true liquidity. The myriad regulatory obligations to which they are held, combined with execution speed, create an enormous vulnerability to gap moves in the marketplace to avoid being forced to buy or sell large block-sized positions without the ability to appropriately hedge exposures in time. This is a far less discussed reason for why the “screens” sometimes appear illiquid.
It’s important to note that regardless of what’s displayed on the “screens,” the liquidity of an ETF is dictated by two main factors: (1) the underlying securities and (2) the hedgeability of those securities. While these factors may appear related, there can be a substantial disconnect between the two during extreme market volatility.
While a traditional block trade is defined as 10,000 shares or $200k in notional value, in less liquid ETFs, it may be thought of as any transaction larger than what’s indicated on the “screens.” For the reasons stated above, there are problems with executing these types of trades in the electronic marketplace. You have to use an execution partner like a liquidity provider or an agency broker. Next month, I’ll discuss the nuances between these two options.
Headquartered in Chicago, WEX specializes in value-added execution, enabling clients to trade equities, options, futures, and ETFs through our proprietary electronic trading platform (WTP), algorithms, floor access, and agency brokerage desk.
This is intended for informational and discussion purposes only and does not create any legally binding obligations on the part of Wolverine Execution Services, LLC and/or its affiliates. Without limitation, this document does not constitute an offer, an invitation to offer or a recommendation to enter into any transaction or investment advice of any kind. For general information regarding the nature and risks of investing please go to www.tradewex.com.