Sunday, July 30, 2017

ETF Liquidity: How Difficult is ETF Market Making?

When Goldman Sachs decided to quit as a lead market maker for ETFs, you have to ask just how liquid ETFs would be in volatile, declining market. Goldman Sachs was dissatisfied with a business that yielded fractional pennies on trades while, as a large bank, it was required to maintain strict regulatory capital requirements for liquidity.  This retreat from the ETF market maker business means that smaller, less regulated firms, which will not have strict capital requirements, will be picking up the Goldman Sachs  ETF market making business and be responsible for the liquidity of ETF trades.

In "ETF Liquidity: A Market Maker's Perspective" and "Understanding a Market Maker's Risk Can Help You Save on Transaction Costs" in this Vanguard publication, there is a discussion of the market maker process.  The articles also advise not attempting transactions at the opening or close of the
market, which is good advice, and using only limit orders, which are orders to buy or sell at a specific or better price.  The problem with a limit order is you risk trade failure, although it will give you more price point control in a normal market.  While a market order may yield a very unsatisfactory result, it will usually transact.  Good until cancelled and stop loss, limit orders are also prone to trade failure in a rapidly declining market.

While an ETF limit order may fail, a market order is likely to yield a disadvantageous price point in a rapidly declining market.  On the other hand, a buy or sell of a mutual fund will always be settled at the end of the market after all of the ups and downs of the day are over.

Two questions to ask when researching an ETF or ETN is how actively traded is it and are the bid/ask spreads small (less costly) or large.  Other questions to consider: Is the ETF tracking an index or market which has more or less liquidity risk than other indexes or markets?  Is the ETF or ETN still issuing shares or has it ceased to issue new shares?

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