Many ETFs Languish. Virtu Wants to Get Paid to Help Fix ThatBy
Obscure rule bans key traders from receiving cash directly
Highlights ad-hoc nature of ETF regulation as assets swell
Virtu Financial Inc.’s billion-dollar purchase of KCG Holdings Inc. this year more than doubled the size of its business that smooths trading of exchange-traded funds.
Now, armed with extra clout, the New York-based high-speed market maker has a 20-year-old U.S. rule in its sights. If the Financial Industry Regulatory Authority revises its Rule 5250, Virtu contends, it can help solve a pervasive problem in the industry by breathing life into small ETFs. About 24 percent of U.S. funds saw less than $100,000 traded each day on average in the past year, according to data compiled by Bloomberg.
The regulation bars traders from getting paid by public companies for buying and selling their stocks -- something designed to prevent conflicts of interest. ETFs are covered, too, but Virtu argues they shouldn’t be.
“Current rules restrict issuers from directing incentives to the products that need the most support,” Doug Cifu, Virtu’s chief executive officer, said during an interview. It would be a more straightforward, level playing field for new entrants if issuers could pay their lead market makers directly and disclose the arrangements, he said.
Virtu is one of a handful of firms that makes markets in ETFs, helping to ensure investors can buy or sell them when they want to. With its KCG deal complete, Virtu leaped to become one of the largest ETF shepherds with extra responsibilities -- called “lead market makers” -- in the U.S. equity market, with more than 500 funds in its purview. Although overseeing trading for high-volume ETFs is a business that pays for itself, it’s less economical to take on that crucial role for products that limp along with low volume.
Along with New York-based Cantor Fitzgerald LP, another ETF market maker, Virtu argues that traders would be more inclined to support small, new funds if ETF issuers could pay them -- arrangements that are already possible in Europe. The U.S. ETF industry’s low barriers to entry and limited incentives to delist, even for funds that don’t trade much, have led to a glut of products with limited assets and trading volume.
Rule 5250 dates to 1997, when a version of it was adopted by one of Finra’s regulatory predecessors, the National Association of Securities Dealers. The issue highlights a tricky reality for ETFs: they’re governed by rules created, in many cases, when the now-$2.5 trillion industry barely existed -- or even before. Though ETFs trade like stocks, in some ways it’s a more complicated business for market makers; ETF market makers actually create units of the fund by first collecting a basket of the underlying shares and then delivering them to the issuer.
“What you’re seeing is another example of how general equity rules need to be reviewed holistically around ETFs,” said Reggie Browne, senior managing director at Cantor.
The rule was put in place to prevent companies from paying brokers to manipulate the price of stocks. However, for ETFs, that’s less likely to happen because their values are derived from prices for a bunch of underlying securities. If a market maker were mispricing a fund, arbitrageurs could swoop in to bring it back to fair value.
Earlier this year Finra asked the industry to comment on several rules, including 5250. Market makers didn’t comment on the topic, preferring instead to press for changes in behind-the-scenes discussions with regulators and onstage at industry events. A spokesman for Finra said, “We are evaluating the comments received and will then determine what changes, if any, to explore.”
Market makers already get rebates for their trading through stock exchanges like Nasdaq and the New York Stock Exchange; Finra created an exception specifically for that. But those rebates are linked to trading volume and are viewed by traders and some small ETF providers as a roundabout way to funnel funds to market makers for their services.
Still, there could be push-back. Other kinds of incentive payments elsewhere in the stock market have been an ongoing flashpoint of controversy. For instance, exchanges pay brokers to send orders their way, something Massachusetts’s Secretary of the Commonwealth referred to as “kickbacks” when announcing an investigation in August.
“When an incentive is tied to trading volume, it’s misaligned,” said Phil Bak, CEO of ACSI Funds and Exponential ETFs. His firm’s products include the $41 million American Customer Satisfaction Core Alpha ETF, which usually only sees a few thousand shares traded each day. “The industry wants to see those incentives aligned.”
Now the pressure’s on to convince the regulators of the same.
— With assistance by Rachel Evans