This article was originally published on Curatia.
By Nasdaq’s Giang Bui, Head of U.S. ETPs, and Carlos Pelaez, ETF Product Manager
By quieting liquidity concerns and fueling a retail-trading boom, the pandemic has unlocked an era of explosive ETF growth. But ETF proliferation has also crowded the on-ramp to success as new and incubating ETFs face off in the quest to build AUM and liquidity.
Nasdaq’s Designated Liquidity Provider program is helping ETF issuers solve that challenge by giving market makers new incentives to provide liquidity in emergent ETFs. Those dynamics are improving transparency and price discovery while reducing transaction costs for both institutional and retail investors — a winning strategy for all market participants.
ETF Explosion
Over the past several years, the number of new ETFs coming to market in the U.S. has increased significantly. These products have grown in popularity among both institutional and retail investors because they can provide efficient access to various markets and asset classes and can be traded intraday like a stock. Moreover, they typically have lower cost and greater tax efficiencies compared to mutual funds. For exchanges, it’s critical to design market structure and incentive programs so new launches have the best chance of success, and investors are assured the best possible choice and trading experience.
Supply hit a record in 2020, with more than 300 new listings in the U.S., and this year the number of launches is trending to be at least the same, if not higher. According to CFRA Research, there were around 200 new exchange traded product launches in the first half of 2021.
On the demand side, investors continue to pour money into core products with broad exposure, but they have also become more attracted to ETFs with more concentrated portfolios that may generate alpha. Among them are thematic ETFs, which target stocks positioned to benefit from potential shifts in technology, society, the environment and demographics over time. ESG has been a hot area for the last several years, and interest is increasing given the Biden administration’s focus on promoting clean-energy and climate goals.
Assets in thematic funds have grown at an average of 45% annually over the past three years. Nasdaq has been the home to many leading thematic ETFs given our alignment with companies advancing these megatrends and corporate commitment to sustainability.
A few issuers are interested in launching cryptocurrency ETFs. Valkyrie Digital Assets, Victory Capital and other issuers have all filed plans for cryptocurrency ETFs recently. That said, the SEC has generally taken a cautious approach to cryptocurrencies and has yet to approve any ETF applications. Nasdaq has been in lockstep with our issuers to navigate the regulatory framework.
As the ETF industry continues to break records in inflows, assets under management, number of new launches and new entrants, we anticipate ETF adoption to accelerate even further. Investors have increased their appetite for the ETF wrapper across product trends such as active management, fixed income, ESG, thematics and cryptocurrencies.
Incentives for Success
Competition in the ETF market is fierce, with more than 2,600 listed ETPs and over 300 new launches each year. Market quality is an important factor for ETFs, especially when they first launch, because it ensures investors receive efficient executions. Yet ETFs typically don’t attract a significant amount of trading volume on day one because it takes time to build investor awareness and a performance track record.
As such, it’s critical for exchanges to offer the best service model and issuer support programs possible. That’s why Nasdaq has rolled out changes to its Designated Liquidity Provider Program (DLP) designed to improve market quality by aligning the program incentives to best fit varying levels of ETF trading volumes.
Nasdaq’s DLP Program dates back over a decade, and it has evolved over time. Ultimately, it’s designed to boost market quality in Nasdaq-listed ETFs by incentivizing market makers for support. A key characteristic has been aligning these incentives with thresholds on market quality metrics, such as the average spread of the ETF. The goal is to keep spreads tight and maintain liquidity at and around the national best bid and offer (NBBO).
Traditionally, the exchange would pay a market maker for providing liquidity per transaction, taking quote quality into account. Under the revised DLP program, however, market makers receive a different style of payment for newly-launched or thinly-traded ETFs. For ETFs that are under the 250,000-share threshold for average daily volume (ADV), Nasdaq gives market makers a monthly stipend on top of their transaction incentives. This helps market makers cover their costs more efficiently, so they can focus on quoting and the market quality in the ETF. It also helps to build a foundation upon which volume and assets under management can grow. Importantly, the structure of the new program is additive: It doesn’t take away from more established ETFs that trade in high volumes.
Nasdaq now has four market quality requirements for ETF liquidity provisioning, which are more stringent than previous requirements. There’s a standard set of requirements, as well as an enhanced set of requirements to further incentivize DLPs for premier market quality in Nasdaq-listed ETFs. The first two requirements are the average percentage of time the DLP is either at the NBBO with a minimum of 100 shares, or within 5 basis points of the NBBO. The other two requirements relate to notional depth and average spread.
In addition to having a primary market maker responsible for facilitating trading efficiency in an ETF, Nasdaq allows for a secondary DLP. The purpose is to further increase liquidity support for ETF issues with lower ADVs. Nasdaq also offers incremental Tape C ETF trading incentives, which reward DLPs based on the number of DLP assignments and their Tape C ETF quoting and trading.
Positive Results
Now that the new DLP program has been running for a few months, we’re starting to see positive results.
On average, DLPs increased their time at the NBBO across all symbols by 3%, while increasing their Time at the NBBO within 5bps by 2%. The notional depth being provided by DLPs within 0.50% of the NBBO has increased by 12%. More than 60% of Nasdaq-listed ETFs saw the growth in their DLP’s notional depth within 0.50% of the NBBO.
Furthermore, we also saw spread reductions in all Nasdaq Listed ETFs across all ADV tiers by 0.02%, and the percentage of Nasdaq-listed ETFs quoted with a spread less than our enhanced requirements of 0.25% increased by 22%.
By realigning our incentive structure to better support new and incubating ETFs, the DLP program helps new launches get off the ground, offering investors more choice and ensuring they receive the best execution possible. It increases liquidity on a lit exchange, which improves transparency and price discovery, and reduces transaction costs for both institutional and retail investors. For market makers, the economics of the program reduce friction and allow them to support a broader array of ETFs. And for issuers, the new DLP program sets their ETFs up for success. In our view, the program is a winner all around.
To learn more about our new DLP program, please contact us at [email protected].
About the Authors:
Giang Bui
Giang Bui is Head of U.S. Exchange Traded Products at Nasdaq, where she is responsible for developing and executing the strategic vision for Nasdaq’s ETP business. Prior to joining Nasdaq, she was a Director of Listings at Cboe Global Markets, where she was focused on ETF business development, liquidity programs, and strategic initiatives. Prior to joining Cboe, Giang played a key role in developing and marketing new indexes at the New York Stock Exchange. She began her career as a business analyst for NYSE’s global index and exchange-traded products group.
Carlos Pelaez serves as a Senior Manager of ETF Listings, focused on business development and managing ETF Issuer and Market Maker relationships. Primarily working with asset managers to navigate the ETF Listings process and lifecycle, as well as managing and building impactful liquidity program solutions for ETF market makers.
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