Resetting The Standards Final

Resetting the Standards:
ETFs Role in an Evolving Buy-Side Tool Chest

Sweeping global regulatory reform in the wake of the financial crisis has upended the traditional
foundations for capital markets trading. Workflows have been altered, infrastructure fractured, and
bespoke products have been thrown into the arena of transparent electronic execution. All this change
is occurring against the backdrop of thinning liquidity in both over the counter (OTC) and listed
derivatives. Meanwhile, rising compliance costs and a revamp of best execution have changed the nature
of how market participants have to assess the cost of trading.
The first- and second-order impacts of regulatory reforms of the global capital markets system are only
now filtering down to trading and investment choices at buy-side firms. Costs have risen, dealer business
models have changed, and the execution standards of yesterday are no longer adequate. For buy-side
institutions active in the listed and OTC derivatives markets the effect has been severe. What has
changed so far, however, may very well pale in comparison to what is to come. The electronification of
opaque markets, exponentially evolving technology, and increased focus on best execution in new areas
such as fixed income will be the great disrupters of tomorrows trading ecosystem.
V15:021
May 2017
www.tabbgroup.com
Resetting the Standards: ETFs Role in an Evolving Buy-Side Tool Chest | May 2017
Introduction
To improve is to change; to be perfect is to change often. - Sir Winston Churchill
There has been a general assumption that much of the market would migrate from the
bespoke (and soon-to-be subject to onerous margin treatments) OTC markets to standardized
and stable futures markets as regulations impose transparency and execution standards on
opaque markets. This futurization of markets within the US and Europe has not played out as
anticipated, giving rise to a new focus on cost and performance within the buy-side and is
expected to drive growth in low-cost, broad-exposure products. For a growing population of
institutional investors, the first-order reaction has been to use an old tool in new ways.
This has meant that the number of buy-side firms Exhibit 1: US Listed ETF Assets Under
directing flow toward the Exchange Traded Fund Management (AUM)
(ETF) market is building momentum. Over 2,000 $5,000
Billions
individual ETFs are available to investors within the
US across asset classes today and well over 5,000 $4,000
globally. Assets under management (AUM) across
ETF asset classes is now over $2.77 trillion, up over $3,000
(400%) from just under $600 billion ten years ago.
TABB Group projects that by the end of the decade $2,000
US listed ETF AUM may very well breach the $5
trillion mark.
$1,000
Roadblocks to the instruments increased adoption

$-
among major buy-side institutions range from a 2007 2012 2017 2022 est.
lack of infrastructure and inadequate internal
Source: TABB Group
instrument expertise to concerns of varying degree
about entering into a market with a perceived lack
of rigorous liquidity testing in times of market stress (although this is only a perception in
many cases).
These concerns, however, are dissipating as more institutions become educated in these
products. TABB research indicates that the range of applications for the ETF among the buy-
side institutions is certainly expanding. For most, the adaptability and broad range of
applications for ETFs across asset classes may counteract any lingering uncertainty with the
underlying market structure.
The many factors driving todays changing ecosystem boil down to more than a shift from
bespoke-to-standardized or OTC-to-electronic. Overarching themes that will continue to drive
the markets evolution are the ease of achieving cross-asset exposure and technological
scalability. The ETF is ideally positioned to benefit from these tides of change, and is at the
front of the pack (and breaking away) of instruments, both old and new, vying for market
share as investors rethink traditional investment strategies.
2017 The TABB Group, LLC. All Rights Reserved. May not be reproduced by any means without express permission | 2
The Financial Instrument ETF

It has been nearly a decade since the financial crisis that set in motion
The big regulatory
sweeping global regulatory reforms across all aspects the capital
change for us has
markets ecosystem. These reforms all translate into a universal reality
just put an extra
for market participants a singular focus on the relationship between
focus on cost.
cost and returns.
(Large Asset
The new bank capital adequacy framework set in place by Basel III has
Manager)
forced significant change within the dealer community. An irreversible
shift has occurred within dealer liquidity provisioning models, and that
rising cost of taking on risk has led dealers to increasingly rely on
riskless principal or order-driven trading models to provide liquidity to
the market. This is a departure from traditional market structure and
has resulted in a liquidity vacuum in some markets.
Exhibit 2: Why do you use ETFs? (by mention)
Easy Broad Exposure to a Variety of Markets
Ease of Use
Low Cost
Fast Execution
Prevents Slippage
Abundant Liquidity
Can Be Lent Out as Equity (Offset Cost)
Additional Liquidity Layer (Underlying & Secondary Arbitrage)
Standardized
0% 20% 40% 60% 80% 100%

Source: TABB Group
I think the only other A rapidly growing population of the buy-side is using an old product with
thing is ETFs have a seemingly new tricks to take on the challenges brought on by regulatory
tremendous amount headwinds. Once the bastion of the retail equity market, traditional
of liquidity even the institutional investors such as asset managers, pension funds, and
stuff you dont see on insurance companies are rethinking how ETFs can fit within their
the tape. Providers strategies. Easy, broad market exposure to a variety of markets was the
today are able to most commonly cited appealing aspect of ETF among the buy-side
create share institutions with whom TABB Group spoke. Low cost and ease of use
efficiently and you were the second- and third-most appealing characteristic of ETFs
can trade large (Exhibit 2). As of year-end 2016, ETFs represent an estimated 13% of
volumes through the estimated $19.2 trillion in net assets held by investment companies
ETFs. in the US according to the Investment Company Institute.
(Large Asset There is a telling duality to the markets narrative on the dramatic
Manager) growth in ETF usage. The majority of buy-side firms TABB Group spoke
to during the first quarter of 2017 explained that while reliable liquidity
and fast, easy access to a variety of exposures across asset classes were
the principal drivers behind ETF adoption, these qualities were not
universal across all ETFs. This theme is consistent with outreach TABB
Group has made in previous years looking into the growth of institutional
ETF adoption. The crux of the issue is that for any given ETF to be a
viable instrument choice there has to be a certain threshold of liquidity
and AUM before it can be used as a viable instrument. For some, the
AUM and maturity of the ETF all were as important of factors in product
choice as is the daily liquidity. For others, as long as there was sufficient
liquidity either in the secondary market or underlying the instrument
they were comfortable trading the ETF.
Exhibits 3 & 4: ETF Usage (Cross-Asset) Among Survey Participants & Plans for Future Allocations
How would you classify your ETF Usage? Do you plan on increasing ETF allocations this year?
Moderate
No Plans to
Increase, Planning to
40% Increase
Large User Allocations,
50%
Undecided,
Minimal 10%
0% 10% 20% 30% 40% 50%
Source: TABB Group
Within the US, new regulation has been the driving force behind broker
disintermediation; this has had a lasting impact on liquidity. As brokers
reevaluate the extent to which they are able to provide coverage to
clients outside of their top priority list, these smaller institutions will
need new means to trade in size. ETFs have become increasingly popular
to fill this role.
Within equities, ETF blocks made up between 25%-30% of the tape in

2016, up from 10%-15% ten years ago according to Goldman Sachs
figures. And while equity ETF blocks today account for up to 80% of ETF
block notional volume traded, according to recent Credit Suisse figures,
The thing is, the ETF a tremendous surge in Exhibit 5: Tradeweb RFQ ETF platform Volumes
makes your life so adoption of fixed income
credit ETFs, where the
Billions
much easier. For a $12
underlying market has
small management
been hit the hardest by the $10
fee you get the exact
liquidity crisis, may soon
exposure you want $8
shift this balance.
from a performance
$6
perspective. Dealing Naturally, as institutional
with the cash demand for block-sized $4
perspective of the ETFs grows, we would
$2
ETF, especially with expect to see growing
fixed income, you do volumes on ETF RFQ $-
need to have some platforms. Looking to
expertise in-house. Tradewebs RFQ ETF
That being said, its platform, which launched Source: TABB Group, Tradeweb
still the easiest way during Q1 2016, we see a

from an asset pattern of growth consistent with the prevalence of institutional
allocation adoption of ETFs as a means of transacting in size (Exhibit 5).
perspective.
On average since 2008, AUM has grown by approximately 20% year-
(Large Pension Fund) over-year for US-listed ETFs. Looking into how these assets have grown
when broken down by ETF underlying, we get a much clearer view into
which segments of the ETF market have seen the largest adoption in
recent years (Exhibit 6).
Exhibit 6: ETF Net Assets Under Management by Underlying (Year-end 2016)

Broad-based domestic equity Global/International equity
$800
Billions
$687
$700
$600
$500 $432
$400
$303 $301
$300 $258
$229
$185
$200 $139 $140 $142
$109 $93 $121 $109
$83 $60 $63
$100 $44 $45 $31
$-
Net Assets 2012 Net Assets 2016

* Includes international, regional, and single country ETFs, but excluded emerging market ETFs
** Bond ETFs represent 99% of the assets within this category
*** Includes funds that are and are not registered under the Investment Company Act of 1940 (primarily invest in commodities, currencies and futures)
Source: TABB Group, ICI
Since 2012, large-cap equity ETFs have seen the largest influx of assets,
growing by $458 billion in less Exhibit 7: Net New Cash Flow to Equity Mutual
than five years. Bond ETFs Funds in 2016
experienced the second-highest $20
Billions
growth over the same period with $10
just under $250 billion in assets $-
added over the same period.
$(10)
$(20)
This growth is consistent with the
results of our conversations with $(30)
the buy-side that there is no $(40)

singular use case or solution $(50)
driving ETF use; rather, ETFs are
being deployed in cross-asset,
multi-purpose roles in a variety of
portfolio types. Looking to net World equity mutual funds Domestic equity mutual funds
cash flow out of equity mutual Source: TABB Group, ICI
funds in the context of rising net

issuance in US ETFs we can also see that some of the assets moving
into equity ETFs is a long-term migration, suggesting the durability of
the ETF adoption trend (Exhibits 7 & 8).
Exhibit 8: Net Issuance of US ETF Shares

$300 $284
Billions
$241
$250 $231
$200 $185 $180

$177
$151
$150
$116 $118 $118
$100
$74
$56 $57
$45
$50
$16
$-
A New Place in the Derivatives Toolbox

Over the past several years institutional investors have found innovative
ETFs have typically
ways to put the ETF to work; principal among them is the application of
been thought of as
ETFs alongside traditional derivatives as a means of managing targeted
passive, and the ones
exposure. TABB Group outreach to the buy-side indicates that the
that are very index-
interplay of the ETF and traditional derivative tools as an access vehicle
based are passive.
is closely tied a variety of factors such as transaction cost, liquidity,
And that is really assets under management, timing, and basis risk. One of the strongest
where the volume area of growth for ETFs within the traditional institutional portfolio today
has gone. is for areas of application with shorter time horizons A trend set largely
in motion by an increasing unwillingness on the part of brokers to
(Large Asset
provide immediacy in balance sheet deployment and universal cost
Manager)
pressures felt among market participants.
Futures
Institutions are progressively opting to replace futures positions or at
least consider ETFs alongside the traditional future as an exposure tool.
Exhibits 9 & 10: US Futures Volume Breakdown & Broad-Based Large Cap Equity ETF Growth
Source: TABB Group, FIA, ICI
Looking at a comparison from 2012 to 2016 between the net assets

under management of US equity ETFs against the breakdown of US
futures volume we see two very different growth stories. Large-cap,
mid-cap, and small-cap equity ETF AUM have all grown by over 200%
since 2012, largely driven by recent utilization by institutions for
exposure over broad index equity futures. Breaking down US futures
volume over that same period we see that the percentage of futures
trading based on equities has dropped from nearly 25% of total volume
in 2012 to just over 20% in 2016. And while the overall volume in equity
futures has grown by a modest 12% since 2012, it is dwarfed by inflows
to broad index equity ETFs on a percentage basis (Exhibit 9 & 10,
previous page).
Futures have a transparent margin cost and are in most cases more
liquid. With a future, you have a roll schedule, whether it is on a
quarterly or monthly basis, acting a constant source of risk over
extended exposure horizons. Regulatory reform driving up the cost of
capital for banks has had the knock-on effect of raising these roll costs
for futures users. Both products trade on an exchange although there
are logistical differences between the two processes such as the fact
that futures have to get cleared through a futures communion merchant
(FCM).
ETFs are very Different considerations come into play on weighing the appropriateness
thematic, and I think of an ETF or future for a specific exposure, but for the most part it boils
down to the time-horizon of the exposure. In the case of short term
the market has been
equitization exercises with only a few days of exposure, the basis
generally moving on
difference between the ETF and future is marginal. When the holding
themes rather than
period is longer, ETFs are often the preferred exposure over a future. In
underlying securities.
many instances, the consistent management fee a client may have to
So I think people
pay with an ETF is preferable to the volatility of roll costs for the future.
would take an
investment decision Similarly, as the time horizon of the exposure expands, the tracking
in the theme rather error becomes a more important factor than the trade cost. Whereas for
than the underlying short terms exposures in the ballpark of weeks rather than months, one
name. could easily make the inverse argument That the trade cost outweighs
the tracking error in the all-in cost equation. The near-term
(Large Asset
consideration of cost is different case to case as trade costs are
Manager)
ultimately a moving target for futures and ETFs. Over a longer horizon,
however, maintaining a position with a future and the cost uncertainty
one endures with roll volatility is an equally, if not more important
consideration for the all-in cost. Nevertheless, management fees for
ETFs will continue to come down as competition among ETF providers
increases and utilization of the instrument builds.
Credit Derivatives
The momentum of growth within fixed income ETFs has been a headline
for several years. Corporate bond ETFs have become the darlings of the
institutional investor community in recent years -and for good reason.
The US credit market has been in the midst of a liquidity drought for
several years, a trend largely driven by a shift in dealer business models
away from principal based liquidity provisioning into an agency model.
Balance sheet capacity for Exhibit 11: Credit ETF AUM vs. Corporate Bond
market making in US credit Market Value
has also shrunk in recent $7,000 $180
Corporate Bond Market Value ($$M)
IG and HY CRedit ETFs AUM ($$MM)

years. $6,000
$160
$140
$5,000
These factors combine to $120
paint a somewhat bleak $4,000 $100
liquidity picture for the US $3,000 $80
credit market. Similarly, $2,000

$60
the credit default swap $40

$1,000
markets have struggled in $20
a post-crisis environment. $0 $0
The US single-name credit

default swap market has
Corporate Bond Market Value IG Credit and HY ETFs
seen a precipitous decline
from $15 trillion in notional Source: TABB Group, Blackrock
outstanding at the
beginning of January 2010 to $5.3 trillion at the beginning of 2017. The
credit default swap index market has seen similar losses with a drop
from $12 trillion to $4.3 trillion over the same period (Exhibit 12).
Conversely, Bond ETF AUM continues to surge (Exhibit 11). In 2016
alone, bond ETF saw $91.9 billion in inflows, making it the fastest-
growing segment of ETFs.
Exhibit 12: US Credit Default Swap & Credit Default Swap Index Notional Outstanding
$14
Trillions
$13
$12
$11
$10
$9
$8
$7
$6
$5
$4
Single Name CDS CDS Index
Source: TABB Group, ISDA, BSDRs, DTCC
While the size of the single-name and index CDS markets even today
eclipses the corresponding ETF market, bond ETFs have nonetheless
shown huge growth over the past couple years and are becoming an
increasingly popular replacement to certain credit swaps in times of

stress. Once again, the equation boils down to basis risk.
For example, an investment-grade Index Credit Default Swap (CDX)

contract has a basis risk against a given small cash bond portfolio and
requires the increasingly costly process of contract rolling. On the other
hand, an IG credit ETF might hold over 1,000 IG bonds and maintain a
vastly superior tracking rate to the underlying basket. That being said,
there are many parallels between credit derivatives and comparable
ETFs, underscoring the recent uptick in adoption alongside derivatives
among sophisticated users of these instruments (Exhibit 13).
Exhibit 13: Credit Derivatives & ETF Structure Parallels

Cash Bonds ETFs TRS CDS Indices
Interest Rate Yes Yes Yes No

Exposure
Credit Yes Yes Yes Yes

Exposure
Diversification Single Name HYG>1000 bonds HY ~ 1000 bonds HY: 100 Names
Trading Venue OTC Exchange & OTC OTC OTC
Counterparty No No Yes No
Risk
Index N/A Market cap weighted Market cap weighted - Equally Weighted rules
Construction - rules based rules based based
Rebalancing N/A Monthly Monthly Semi-Annual
Ability to short Yes Yes Yes Yes
Ability to lend Yes Yes No No
Ability to No Yes Yes Yes

trade options
Costs B/o Spread Management fees Transaction cost, if B/o spread

B/o spread held to expiration
Early break fees on
notional Rolling
costs, funding cost
Liquidity Name Centralized Limited group of Multiple dealers

Provided Dependent Exchange Liquidity, dealers as OTC
Multiple Dealers
Pricing Upon request Real-time, intraday Upon request as OTC Upon request as OTC
as OTC on-exchange
Maturity Fixed term No maturity Fixed term Fixed term
Benefits Security Liquid, inexpensive Diversified basket of Liquid, inexpensive

selection execution cash bonds that track basket of CDS exposures
Precise ALM Diversified basket of the market offering pure credit
cash bonds that spread exposure
track the market
Considerations High Requires a custodian - High transaction Standard ISDA contract,

transaction or broker to execute costs; potentially high OTC with counterparty
costs Uneven trades roll costs & early break risk and cleared centrally
liquidity Many fees Standard ISDA with trade reporting to
line items contract, OTC with DTCC Can exhibit
counterparty risk sustained periods of
significant tracking
difference vs. cash bonds
Source: Blackrock, TABB Group
Under ordinary conditions, basis risk has not historically been an issue
for CDX hedging; however, in recent years repeat market stress events
have created a large basis between the cash bond and CDX spreads,
diluting the effectiveness of the instrument to hedge cash market
exposure during difficult market conditions. The same IG ETFs, on the
other hand, have historically tracked the underlying index and broader
cash market very efficiently, particularly during market stress events.
In addition to CDS indices and cash bonds, credit index total return
swaps (TRS) are also in some instances losing ground to credit ETFs.
Breaking down the benefits of a credit ETF compared to a credit index
TRS comes down to cost, leverage requirements, tracking efficiency,
and the added step of taking on counterparty risk for the TRS and
ancillary documentation/time needed to put the swap in place.
Options
ETFs have been steadily gaining market share within the options market.
Breaking down US options volume by underlying, we see that despite
an overall stagnation in US options contract volume, ETF and index
options have seen growth in terms of overall option trading market
share.
Exhibit 14: US Options Breakdown Q1 2017
Since 2007, ETF option
volume has grown from
representing 22.4% of
total volume to nearly 40% Index, 11.8%
today (Exhibit 15, next
page). Looking specifically
to Q1 2017, ETFs account
for roughly 39% of trading Single Stock,
49.0%
volume (Exhibit 14).
This could be taken as a ETF, 39.2%
proxy for the development

of a more efficient market.
A growing interest in
options on ETFs indicates Source: TABB Group, OCC
institutional interest in a product, with the addition of multiple sources

of liquidity (incorporating speculative flows).
Exhibit 15: US Options Volume Breakdown
100%
90%
48.6%
49.0%
80%
52.6%
53.9%
54.9%
55.3%
56.6%
60.6%
61.3%
63.6%
68.1%
70%
60%
10.7%
11.8%
50%
10.0%
7.4%
9.9%
9.4%
8.0%
40%
32.0% 7.4%
30.4% 8.3%
29.6% 6.8%
22.4% 9.5%
30%
40.6%
39.2%
38.7%
37.3%
35.3%
35.3%
35.2%
20%
10%
0%
ETF Index Single Stock

Source: TABB Group, OCC
Institutions are utilizing ETF options as a means of hedging exposure,

capturing alpha, and gaining exposure to the global market. Ranking
So as the market
annual US options volume by name underscores these trends. SPY and
gets more developed,
IWM (broad equity ETFs) alone represented just under 20% of the total
and transaction costs annual options volume for
come lower and lower 2016. Options on EEM, Exhibit 16: Most Actively Traded Options 2016
and lower, we will which provides exposure Rank Name 2016 Volume
start to get a very to mid- and large-cap 1 SPY 671,661,453
pointed exposure for emerging market equities 2 SPX 257,953,004
very little transaction was the eighth most
cost. I think this is 3 VIX 148,246,402
traded option for the full
bound to happen in year (Exhibit 16) 4 IWM 140,662,647
the short term since 5 AAPL 138,727,437
there are a lot of
6 QQQ 111,873,109
providers out there Following this pattern to
and competition its natural conclusion 7 BAC 93,557,840
pushes prices suggests the potential for
8 EEM 87,941,483
downward. I see them new growth among
9 VXX 74,118,316
being used more and certain ETF instruments.
10 FB 7,027,952
more. This means Source: TABB Group, OCC
increasingly tighter That is, as the options
costs, more liquidity market continues its transition to a more ETF-concentrated stasis, the
the progress kind of liquidity feedback loop of the options and underlying instrument build
up investor confidence in the most traded ETF names (just as SPY
feeds itself.
benefited from the snowball effect of liquidity begetting liquidity).
(Large Asset
Manager)
The Evolving Derivatives Landscapes

US Derivatives Ecosystem
Liquidity in all Within the US, much of the derivatives markets transformation has
products whether already played out. Dodd-
derivatives or cash, Frank was a paradigm shift Exhibit 17: Impact of Regulation on Derivatives
Trading
the amount of capital for OTC derivatives trading
committed by and the impact and
individual brokers, aftershock of what has
European brokers or been implemented is still
Minimal
US based brokers being felt across the fixed Impact,
has been adversely income markets. Much of 20%

Significant
the once-opaque market Impact, 50%
impacted. The ability
for interest rate
to find multiple
derivatives and credit Moderate
brokers to quote Impact, 30%
default swap market has
prices on derivatives
been shifted onto swaps
or even cash is
execution venues (SEFs)
limited. The breadth
and while there were initial
of book has really pains, volumes have been Source: TABB Group
gone away. stable (Exhibit 18). Since
2014, the average monthly notional volume traded in interest rate
(Medium Asset
derivatives (excluding FRAs) within the US was $8.3 trillion. As of the
Manager)
first quarter of 2017 this monthly average is now at just under $11
trillion. Index credit default swaps average monthly notion volume on
the other hand has fallen by around 8% for a 2017 average of just under
$350 billion over the same period (Exhibit 11, page 9).
Exhibit 18: Notional Volumes, Interest Rate Derivatives and CDX
$9 $600
Interest Rate Derivatives, Trillions $USD
Index Credit Default Swaps, Billions $USD

$8
$500
$7
$6 $400
$5
$300
$4
$3 $200
$2
$100
$1
$- $-
IRD On SEF IRD Off SEF CDX On SEF CDX Off SEF
Source: TABB Group, ISDA, DTCC, BSDRs
Central clearing is the new reality and the majority of interest rate swaps
are cleared within the US markets. In the coming months global
regulators are expected to implement the delayed March 1 st variation
margin obligations for uncleared swaps, increasing the pressure on

many market participants to reconsider the total cost of their
allocations.
Looking to the listed futures market, growth in recent years have been spread
relatively evenly across underlying types. For the full year of 2016 US futures
volume saw and increase of 13% year over year to an all-time high
annual volume of 3.6 billion contracts. Options on futures also saw a
similar growth of 13% year over year (Exhibit 19).
Exhibit 19: Annual US Futures Volume, Millions of Contracts
Source: TABB Group, FIA
Listed options trading volume has not experienced the same growth in
volume seen with listed futures. Options trading so far in 2017 has seen
some upticks over previous quarters, but year-on-year overall volume
of 1.03 billion contracts was a 1.6% drop since Q1 2016. Despite large-
scale market events including the US presidential election cycle and
Brexit, the impact of prolonged record-low volatility prevailed (Exhibit
20).
Exhibit 20: US Options Annual Volume, Billions of Contracts
Source: TABB Group, OCC
European Trading Ecosystem

The European framework that will be fully implemented by January 2019
is significantly different from the US in ways that will fundamentally alter
the ways participants trade with each other. Rather than applying
mandatory trading on specific venues, the European Markets in Financial
Instruments Directive (MiFID II) and Regulation will extend the pre-
existing equities regime to all asset classes.
Market participants have the option to select venues with different

designations (Regulated Markets, Multilateral Trading Facilities and
Organized Trading Facilities) to tailor their trading needs (Exhibit 21).
Each of these is subject to different transparency and reporting
standards, meaning a greater need for data capture, organization and
analysis than has been the case in many asset classes to date.
Exhibit 21: Venue Designations Under MiFID II
MiFID II Designation Description
Bilateral market-makers trading own principal will be required to become SIs

Systematic Internalizers
Subject to extra pre-trade and post-trade transparency requirements (pre-trade
(SIs)
pricing, executable
Regulated Markets (RMs) & Alternative to exchanges to foster competition

Multi-lateral Trading Secondary markets only, non-discretionary existed under MiFID I for equities
Facilities (MTFs)
Equivalent of US Swaps Execution Facilities (SEFs)

Organized Trading Facilities Liquidity aggregator
(OTFs) Pre & post-trade services
Does NOT apply to equities (2 year review)
Source: TABB Group
More sector ETFs Like the US, it is true that a narrow band of liquid, standardized
would make a contracts will be traded on venues but across asset classes. On the face
difference for a more of it, this should be great news for cross-asset strategies as fungible
developed market in data will be forcibly published in public. This will be an advantage to
Europe. In Europe market-making firms within Europe, the presence of which will further
you only get speed the development of the market.
European sector
Respondents to Tabb Groups interviews with European buy-side firms
ETFs, you cant get
stated that legal, reporting and documentation burdens have already
US sector ETFs and
been the largest factor affecting these firms today. The updating of swap
its not cheap the
documentation to reflect collateralization requirements for uncleared
other ways of
swaps have been a huge issue over the last two months as the
accessing them.
implementation of the related European Market Infrastructure
(Large Asset Regulation (EMIR) gets phased in.
Manager)
The earlier roll out of mandatory clearing for some swap contracts has
also meant that mandatory clearing has had a much more limited impact
than in the US experience, where the execution infrastructure was

I think if the whole
established at the same time. Understanding the effect of the
market will be
introduction of margin requirements for swaps, and the overhaul of
electronified, the
documentation and reporting standards, will be dependent on the firms
whole market will go
currently finalizing registration as venues.
there. In the face of
all-to-all trading,
dealers cant stand Best Execution and Relative Pricing
up for the risk people A rare instance of Europe potentially leading the way for other markets
need to transfer. The is in best execution and pricing transparency in the new regime. Under
buy side will always the new regime, firms will have to provide factor-based information for
push it where they free at least annually that tracks best execution. These factors will be
can because of the clustered around price, cost, speed and likelihood of execution. To
pressure to document unpack that slightly, the first two will be crucial in developing two-way
best execution. Its a markets in OTC alternative products such as futures and ETFs. Those
lot easier to European respondents that have seen no change in their use of such
electronify exchange products cited opacity of pricing and uncertainty on cost as main factors
traded markets than driving that decision. Clear preferences for OTC products remain from
OTC markets to see portfolio managers that have built expertise in those product sets but
that you achieve best all agreed that use of standardized and venue traded products was likely
to rise.
execution."
(Large Asset In Europe, the lack of a need to report bilateral trades has exacerbated
Manager) the problem even in equities covered under MiFID I. That dearth of
information, coupled with the fact that most ETFs (despite the name)
have been traded off-exchange and with dealers on an RFQ basis have
increased the problem. This will likely change as price transparency
increases with pre and post trade transparency.
New Challenges, New Costs

The introduction of a new capital adequacy framework has wider
Bank capital rules implications than simply reducing liquidity. The new constraints on
are making things dealers looking to deploy
more expensive. The capital are changing the Exhibit 22: Has the Cost of Compliance Increased
for Your Firm Post-Regulatory Overhaul?
logistical aspects in way the buy-side chooses
terms of the to trade (as costs are
infrastructure and the passed through to the
pipeline were a huge client). Among the buy-
cost in terms of man side firms TABB spoke to, Marginally,
10%
hours, infrastructure 80% responded that there
has been a significant
Moderately,
and development- 10%
things like that. increase to the compliance

Needed or not, we costs their firm must
overcome, while the Significantly,
really didnt really 80%
balance said that the cost
have a choice.
pressure was moderate to
(Large Pension Fund) marginal (Exhibit 22).
Increased costs, the direct Source: TABB Group
and indirect impact of bank

capital rules, and liquidity were consistently the top three issues
participants in the study cited as principal challenges facing the
derivatives market (Exhibit 23). On a broader scale, the capital rules
have diminished the flexibility of banks to take on risk; this has
implications that extend beyond derivatives. The way in which the cost
of these new rules has been passed on to the buy-side varies instrument
to instrument, but there is a common thread liquidity has been
diminished. We expect this pressure to herald a continued migration to
low cost product alternatives to increasingly costly derivatives.
Exhibit 23: Biggest Challenges Facing Derivatives Users Today (Cross-Asset), (by mention)
Cost
Bank Capital Rules
Liquidity
Compliance
Legal Documentation
Infrastructural Changes
Collateral Management
Reporting
Counterparty Selection
0% 10% 20% 30% 40% 50% 60% 70%
Source: TABB Group
(Expect a migration Within the OTC derivatives markets, for instance, many participants
out of OTC lamented that spreads have noticeably widened as a result of leverage
products?) I guess costs being accounted for in pricing most noticeably in interest rate
we are not there yet. swaps and FX. Some firms, looking to stay ahead of the curve, have
begun the shift, to a minor extent from FX forwards to the more
Im a strong believer
standardized FX futures space. These steps, so far, have been tentative
that it will happen but
and liquidity not up to par with the OTC market in which brokers are
as I said it might take
more willing to provide coverage.
another one, one and
a half years.
Allocations Shift
(Large Asset
Manager) Among the buy-side Exhibit 24: Do you expect to see a migration out
participants TABB Group of OTC instruments?
90%
spoke with, 80% No, 80%
expressed that they have 80%
not observed nor do they 70%

expect to see any
60%
substantial migration out
of OTC instruments to 50%
listed exchange products. 40%

20% expressed that they
30% Yes, 20%
You dont have the expect some migration to
occur in a post-global 20%
liquidity yet. Too Early, 10%
regulation implementation 10%
Obviously OTC is
scenario (Exhibit 24).
less transparent and 0%
No Yes Too Early
less transparent
While there are many Source: TABB Group
means higher
factors contributing to the
margins for the sell
lack of movement from OTC to exchange traded products, for the
side. So are the majority of the buy-side firms TABB interviewed, the status-quo not
broker firms keen to changing boils down to a few fundamental truths: there is not adequate
shift the noose from a liquidity within listed markets to absorb the size of the equivalent OTC
high margin OTC product, firms do not want to abandon the benefits of bespoke exposure
world into a lower through OTC contracts, and the margin requirements expected for the
margin, more OTC markets did not turn out to be as onerous as anticipated.
transparent, listed
one? Which is clearly Looking at notional volumes within the US OTC and listed derivatives
where regulation plus trading markets, a shift has already occurred, rather than a migration.
buy-side has to be in US investors have opted to increasingly trade traditionally OTC
the drivers seat to instruments on new regulated venues (SEFs) rather than undertake a
push brokers into this shift to a new asset class such as futures. In early 2014, when SEF
direction. trading was in its infancy and mandated execution for certain interest
rate derivatives and index credit default swaps were still being rolled
(Large Asset out, more than 70% of the notional trading volume for IRD was still
Manager) being traded away from regulated venues today that figure is closer
to 55-60%. The shift has been even more pronounced for CDX, where
There have certainly SEF trade volume has grown from around 40% to just under 80% of
been second hand notional volume as of March 2017 over the same period. As stated
(regulatory) knock on above, issues with trade reporting, documentation and data sharing
have been a serious hindrance for many market participants in Europe
effects that have
as a much wider regime is implemented.
changed our
behavior.
Theres an ETF for That
(Large Asset
Manager) By all indications, the adoption we have seen of the financial instrument
ETF is stable if not permanent. Strong asset inflows and deepening
liquidity across underlying assets (each with their own market forces
driving growth) coupled with an ongoing retraction of traditional liquidity
pools year after year all spell continued institutional adoption of ETF
trading. As discussed earlier, a new paradigm has developed for trading
ecosystems across global markets, and reducing costs and efficiently
managing risk are top priorities for the buy-side. The continued rise of
the ETF is inexorably tied to this new market paradigm.
We do a lot of
customized things Bond ETFs have the strongest growth momentum in recent years. This
that are harder to do trend has been fueled by ongoing liquidity challenges within the
now but on the investment-grade and high-yield credit markets. Bond ETFs are being
positive side if you increasingly utilized as an extra layer of liquidity in the absence of
want quotes you dont traditional dealer liquidity provisioning. While equity blocks still make up
have to call ten the lions share of ETF volume, fixed income ETF blocks are the fastest
people because you growing among the underlying asset classes.
have figures on a
screen, but it doesnt Secondly, the exposure fixed income ETFs provide is somewhat novel
that those figures are and new compared to the well-established equity ETF market. For
executable in size. instance, futures on broad equity indexes are liquid and readily
available, while bond ETFs provide easy, fast and cheap broad fixed
(Large Pension Fund) income exposure where it would have otherwise been difficult to source
the bonds or replicate with alternative instruments in the past. With a
bond ETF it is simply a matter of executing a trade on a share of an ETF
to get the entire slice of a given index. The variety of ways in which
traditional intuitional investors such as asset managers, insurance
companies, and pension funds are utilizing these ETFs range from a
means of adding liquidity, strategic allocation, or fund flows to name a
few.
This of course leads into a topic that is still very much polarizing among
institutional investors: the primary and secondary market liquidity
dynamic, or rather the potential liquidity mismatch between the two.
And although this concern is still prevalent among the buy-side, when
less established (low ADV, low AUM) ETFs arent entangled within the
more robust ETFs, the data very much backs of the durability of financial
instrument ETFs. Take HYG, which just celebrated its 10th anniversary
of trading on exchange, as an example. HYG is one of the most liquid
ETFs available today and provides exposure to over 1,000 high-yield

corporate bonds. Despite the tremendous liquidity available in the
secondary market, hypothetical down pressure the underlying
(potentially illiquid) bond market might cause in times of market stress
is a concern. For others, looking to the historical examples available,
performance in times of stress has been a selling point. HYG made its
debut in 2007, just months before the financial crisis took hold of the
markets, and since then has endured a handful of market stress events.
Proponents of the ETF argue that these instruments are actually a
benefit to the market as they provide liquidity at a time when exposure
through the underlying is difficult and pricing opaque (Exhibit 25).
Exhibit 25: HYG Volume & Redemptions During Taper Tantrum
$400 $1,600
Exchange Volume ($MM)

Creates/Redeems ($MM)
$300 $1,200
$200 $800
$100 $400
$0 $0
-$100 -$400
-$200 -$800
-$300 -$1,200
-$400 -$1,600
Create/Redeem Volume
Source: TABB Group, Blackrock, Bloomberg
Looking to exhibits 26 and 27, we can see clear progressive growth in

the size of fund flows for a high-yield and investment-grade credit ETF.
This growth indicates that APs are increasingly comfortable relying on
the creation/redemption process to either source bonds or sell bonds at
institutional sizes and coincides cleanly with an overall surge in AUM for
the credit ETF market.
Exhibits 26 & 27: HYG & LQD 5 day rolling net flows
HYG LQD
Source: TABB Group, Blackrock, Bloomberg
The Adapting Broker Business Model

ETFs are bridging silos among major US dealers. Forward-thinking banks
have begun to take a cross-asset approach to providing liquidity and
service to their clients by integrating trading ETF desks. The functional
capacity necessary to utilize the full potential of the cross-asset ETF
ecosystem is a massive undertaking in terms of technology, risk
management, sales, and most importantly, expertise for dealers.
Exhibit 28: Broker Cross-Asset ETF Business Integration Ecosystem
Source: TABB Group
In recent years large US dealers have taken many organizational steps

in order to build out their cross-asset ETF business. Just how this
arrangement plays out varies greatly bank to bank. For many dealers,
consolidation has been the key step. Many have taken the approach of
consolidating credit index businesses, trading Total Return Swaps
(TRS), Index Credit Default Swaps (CDX), and credit ETFs all off the
same book.
The unique opportunity ETFs afford the broker dealers in the space (and
non-dealer market makers in the ETF) that are Authorized Participants
(APs) are in the creation and redemption process (Exhibit 29, next
page). The complexity of managing this workflow is particularly unique
when placed in the context of a multi-asset market in the sense that it
is cross-discipline expertise that requires risk and trading expertise
within very different market microstructures.
Exhibit 29: ETF Trading Ecosystem
Source: TABB Group, Blackrock
Abating Concerns
The main concern regarding increased ETF allocations among buy-side
firms TABB interviewed was depth of liquidity (Exhibit 30). Many firms
felt that outside of the top ETFs in which block liquidity is concentrated,
trading in size is a risk. For instance, take a large institution trading an
ETF with 2 billion in liquidity that needs to trade 200 million of it: They
will seriously affect the basis, which from a performance perspective
could cause a penalty on the firms relative performance versus the
benchmark.
Exhibit 30: Top Concerns with ETF Usage, (by mention)
Lacking Liquidity
Tracking Error Concerns (Among less liquid ETFs)
Underlying Market Dynamics
Regulatory Uncertainty
ETFs Pricing too Opaque
Limited Availability in Europe
0% 10% 20% 30% 40% 50% 60% 70%
Source: TABB Group
The answer to these

ETF liquidity so far Exhibit 31: ETF Liquidity Dimensions
concerns lies in the unique
hasnt been tested in liquidity structure of the Total ETF Liquidity
any significant way. ETF. ETFs enjoy a dual
This is a very real liquidity profile in which Underlying Basket
concern around the the exchange volume
fact that these visible on any given ETF Exchange ADV
securities provide trading day is only a slice
Related
of the comprehensive pool Derivatives
immediate liquidity
of liquidity the ETF
while the underlying represents (Exhibit 31).
bonds or loans may ETF investors looking to
Correlated
take weeks to settle gauge the liquidity Trading
in some cases. available for a particular Vehicles
ETF need to consider not
(Medium Asset only the exchange volume,
Manager) but also the index of the Source: David J Abner, 2013, Visual guide to ETFs,Hoboken, N.J.:
John Wiley & Sons
ETF itself, the liquidity of
the underlying basket, and the market-making capacity available within
these divisions of the ETF liquidity profile.
A robust market for related derivatives such as options (in which we

have seen strong growth) is an indicator of sophisticated trading utilizing
that sector. Exhibit 32 breaks down the median number of liquidity
providers for an ETF by underlying asset class as well as the median
number of APs that are also registered market makers.
Exhibit 32: Secondary Market Liquidity Providers Breakdown by Underlying Asset Class (December 2014)
25
20
15
10
0
All Domestic Equity International Equity Bond and Hybrid Emerging market Domestic high-yield Emerging market
Equity bond bond
Median number of liquidity providers for an ETF

Median number of Authorized Participants that are registered ETF market makers
*Here liquidity provider is consider to be entities that regularly provide two-sides quotes on ETFs
Outside of liquidity concerns, the principal roadblock to further buy-side

adoption is within trading infrastructure. Depending on the type of
institution, investment mandates, and legal documentation required,
there may also be limitation to how much a fund can own in ETFs.
There are also legal restrictions to the exposure allowed through ETFs
in any one product. Traditionally, fixed income shops that only have
infrastructure set up to trade fixed income securities may not be capable
of trading equities and will need to rework existing internal
infrastructure in order to trade ETFs. This can be a long and expensive
process and the majority of buy-side firms interviewed for TABB Groups
2017 Institutional Equity Trading study plan on taking the wait-and-see
approach to the growing ETF presence within the marketplace.
One European asset manager remarked that more standardization in

European markets
regarding pre- and post- Exhibit 33: How Will Increased Regulation
trade processing would Concerning ETFs Affect the Market?
lead to more utilization of

the product. For now,
though, the opacity of the
market and difficulty with Negative,
ETF price discovery are 10%
barriers to increased
European ETF adoption,
Unsure, 30%
although the majority of Positive, 60%
buy-side firms TABB Group
spoke to felt that new
upcoming regulatory
changes within the
European market would
drive more ETF flow Source: TABB Group
(Exhibit 33).
Conclusion
In the years following the financial crisis, little of what might be considered the traditional
world of capital markets was left untouched. Unprecedented regulatory reform was planned
out and set in motion on a global scale. Within the US derivatives markets in particular,
change has been swift. Once an opaque and bespoke market, today a significant portion of
the major US OTC markets are executed on regulated, electronic venues and this percentage
is growing. Clearing also continues to gain momentum. Despite all of the change accomplished
so far, implementation carries on. As investors in the US acclimate to a new market structure
with a clear preference for standardization, European investors must wait as some of the most
critical regulatory reforms to date are still on the horizon.
In the early days of the global regulatory overhaul many expected that a massive migration
out of OTC markets into standardized listed markets would occur. And while some shifting
has occurred, the change has not been wholesale. Instead, investors have rolled with the
regulatory punches and accepted the new reality.
Dealers have also struggled. Bank capital rules set in place by the Third Basel Accords have
altered the way in which US dealers are willing to provide liquidity to the market and in the
absence of traditional coverage, the buy-side has found new ways to adapt. For many
institutional investors, all of this change translates into a simple overarching focus- reducing
cost and managing risk.
This widening demand from the buy-side for adaptable instruments with reliable liquidity
across asset classes has driven a dramatic growth in ETFs in recent years. As of December
2016, ETFs make up an estimated 13% of the $19.2 trillion in net assets held by investment
companies in the US and this figure is gaining each year, according to the ICI. A growing
percentage of institutional investors are utilizing ETFs across asset classes to overcome the
rising cost of compliance and liquidity challenges regulatory reforms have brought about.
It is certainly true that asset managers, pension funds, and insurance companies are
rethinking how ETFs can fit within their strategies. Easy broad-market exposure, functionality
as a low-cost alternative to increasingly expensive derivatives, and the ability to put money
to work quickly are enduring selling points for the financial instrument ETF. As the global
market invariably grows in complexity and cost, adaptive tools such as the ETF that promote
low-cost simplicity will continue its rise to prominence.
About
TABB Group
TABB Group is the international research and consulting firm focused exclusively on capital
markets, founded on the interview-based research methodology developed by Larry Tabb.
Since 2003, TABB Group has been helping business leaders gain a truer understanding of
financial markets issues to develop actionable roadmaps and approaches to future growth. By
accurately assessing their customer base, competition, and key market opportunities, TABB
Group works with senior industry leaders to make critical decisions about their business. For
more information, visit www.tabbgroup.com.
TABB Groups Fixed Income Research Practice

TABB Groups Fixed Income research, led by TABB Group CEO Anthony J. Perrotta, Jr.,
examines trading, operational and technology issues impacting corporate bonds, treasuries,
swaps, and other credit and rate derivatives in North America, Europe and Asia. This includes
deep dives on market structure, business models, execution venues, central clearing, prime
brokerage, technology, market data, and compliance. Our research is used by legislators,
regulators and market participants worldwide to make strategic and policy decisions
surrounding fixed income trading and OTC derivatives reform.
Fixed Income Team

Primary Analysts:
Radi Khasawneh
Senior Analyst
[email protected]
An experienced journalist covering derivatives and market structure, Radi Khasawneh was named
analyst in fixed income research in June, 2013. He brings 7 years of experience as a financial journalist
specializing in the risk management and the derivatives industry, for Euromoney, CreditFlux, Dow Jones
and Bloomberg. At TABB, his research and commentary will cover corporate bonds; credit and rates;
derivatives; exchange-traded derivatives; MiFID II; post-MIFID market surveillance; hedge funds;
organized trading facilities; OTC regulatory reform in Europe and MiFIR. Since joining, he has co-
authored a report on swap execution facilities following the publication of final rules by the CFTC and
authored a report covering US on-the-run Treasuries.
Colby Jenkins
Analyst
[email protected]
Colby Jenkins joined TABB Group in August 2012. Before joining TABB, he was a Global Academic Fellow
at New York University Abu Dhabi in the UAE, serving as a faculty member in their physics and
mathematics departments. He graduated from New York University, earning a BS in physics with
additional focus on mathematics. As an Analyst, Colby works within both the TABB consulting service
and research group. As an analyst, Colby works within the Fixed Income research group.
Anthony J Perrotta Colby Jenkins Radi Khasawneh

CEO Analyst Senior Analyst
[email protected] [email protected] [email protected]
www.tabbgroup.com
New York
+ 1.646.722.7800
London
+ 44 208 133 5022

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ETFs Role in an Evolving Buy-Side Tool Chest

To improve is to change; to be perfect is to change often. - Sir Winston Churchill

Roadblocks to the instruments increased adoption

The Financial Instrument ETF

Exhibit 2: Why do you use ETFs? (by mention)

Easy Broad Exposure to a Variety of Markets

Can Be Lent Out as Equity (Offset Cost)

Additional Liquidity Layer (Underlying & Secondary Arbitrage)

0% 20% 40% 60% 80% 100%

0% 10% 20% 30% 40% 50%

Source: TABB Group

Within equities, ETF blocks made up between 25%-30% of the tape in

still the easiest way during Q1 2016, we see a

Exhibit 6: ETF Net Assets Under Management by Underlying (Year-end 2016)

Net Assets 2012 Net Assets 2016

the buy-side that there is no $(40)

cash flow out of equity mutual Source: TABB Group, ICI

funds in the context of rising net

Exhibit 8: Net Issuance of US ETF Shares

$200 $185 $180

Source: TABB Group, ICI

A New Place in the Derivatives Toolbox

Source: TABB Group, FIA, ICI

Looking at a comparison from 2012 to 2016 between the net assets

has also shrunk in recent $7,000 $180

Corporate Bond Market Value ($$M)

IG and HY CRedit ETFs AUM ($$MM)

paint a somewhat bleak $4,000 $100

liquidity picture for the US $3,000 $80

credit market. Similarly, $2,000

the credit default swap $40

The US single-name credit

Single Name CDS CDS Index

Source: TABB Group, ISDA, BSDRs, DTCC

increasingly popular replacement to certain credit swaps in times of

For example, an investment-grade Index Credit Default Swap (CDX)

Exhibit 13: Credit Derivatives & ETF Structure Parallels

Interest Rate Yes Yes Yes No

Credit Yes Yes Yes Yes

Trading Venue OTC Exchange & OTC OTC OTC

Rebalancing N/A Monthly Monthly Semi-Annual

Ability to short Yes Yes Yes Yes

Ability to lend Yes Yes No No

Ability to No Yes Yes Yes

Costs B/o Spread Management fees Transaction cost, if B/o spread

Liquidity Name Centralized Limited group of Multiple dealers

Maturity Fixed term No maturity Fixed term Fixed term

Benefits Security Liquid, inexpensive Diversified basket of Liquid, inexpensive

Considerations High Requires a custodian - High transaction Standard ISDA contract,

Source: Blackrock, TABB Group

This could be taken as a ETF, 39.2%

proxy for the development

institutional interest in a product, with the addition of multiple sources

ETF Index Single Stock

Institutions are utilizing ETF options as a means of hedging exposure,

The Evolving Derivatives Landscapes

has been adversely income markets. Much of 20%

Index Credit Default Swaps, Billions $USD