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Japan ETF Spreads Spike
By Paul Amery | 22 March, 2011

On Tuesday March 15, following two days of sharp declines in Japan’s stock market, a London-based retail investor placed an order with his online broker to buy Lyxor’s Japan (Topix) exchange-traded fund (LTPX).  Noticing later in the day that the order had not been transacted until nearly two and a half hours after the initial trade request, which was entered on the broker’s website at 9am, he queried the delay.   ETFs are, after all, supposed to be tradeable instantaneously throughout the day.

It turned out that Société Générale, parent bank of Lyxor and the sole official market maker for the London Stock Exchange’s listing of LTPX, had failed to post bid and offer prices for the fund not only for most of Tuesday morning, but also for the majority of the time since Japan’s earthquake and subsequent tsunami struck in the early morning (European time) of Friday March 11.

Only on Wednesday and Thursday, March 16 and 17, by which time the Japanese equity market had started to recover from its post-earthquake drop of nearly 20%, did LTPX’s market maker return to full-time quoting duty.  When doing so, the market maker posted dramatically wider bid-offer spreads on the London Stock Exchange than had prevailed prior to the tsunami.  Over those two days, LTPX’s on-exchange bid-offer spread ranged from 150 to 700 basis points, ten to fifty times more than the spread prevailing on 10 March, the last day before the earthquake.

In the charts below, which are based on data supplied to by an ETF market maker, sourcing price quotes from Bloomberg, average bid-offer spreads from the London Stock Exchange are calculated on a non-time-weighted basis for each minute over the trading day.  The charts cover the six (trading) day period from Thursday 10 March to Thursday 17 March, inclusive.

LTPX is a relative minnow in the ETF market – it’s the smallest London-listed exchange-traded fund tracking Japanese equities, with around £10 million in assets.  Although it’s an oft-repeated maxim that the liquidity of an ETF reflects the liquidity of its underlying constituents, in practice it’s generally accepted that the size of a fund affects the tightness of spreads in secondary market trading: the bigger the fund, the better the liquidity.  So how did the market makers in larger European ETFs cope with the post-tsunami volatility?

According to the Deutsche Bank February 2011 European ETP directory, the iShares MSCI Japan ETF (IJPN LN) and the db x-trackers MSCI Japan TRN Index ETF (XMJP LN) are the largest two funds in the Japan country fund category with London listings.  These funds, it turned out, also saw a widening of their bid-offer spreads post-tsunami on the London Stock Exchange, dramatically so when it came to the London listing of XMJP.

It’s worth noting the remarkable complacency of market participants during the European trading day of Friday 11 March.  It was only after the weekend, by which time images and accounts showing the full scale of the disaster had emerged, that market prices in Japanese equities – and bid-offer spreads in associated ETFs - reacted.

On Monday and Tuesday 14 and 15 March the London Stock Exchange bid-offer spread for XMJP spiked to near or above 1000 basis points on several occasions.  For an investor placing a market order to buy or sell at these points in time, the net result would have been a trading cost equivalent to twenty years’ worth of management fees on the fund (XMJP charges 0.5% per annum).

While iShares’ IJPN  (which charges 0.59% a year) didn’t record such high levels of dealing spread in its London listing as XMJP, the fund did record an average bid-offer gap of nearly 3% during individual minutes of the trading day on Tuesday 15 March – again, several years’ worth of fees.

The high bid-offer spreads recorded by London-listed ETFs tracking Japan during the last week call into question both the suitability and the enforceability of the rules imposed on traders by the London Stock Exchange.

According to the exchange’s published market maker obligations for exchange-traded products, official traders in an ETP face two major requirements: to maintain bid-offer spreads in at least one “exchange market size” within an applicable maximum spread band (1.5%, 3%, or 5%, depending on the ETP); and to post bid and offer prices within 90 seconds of the exchange’s opening auction each day, and then continuously during the trading day (subject to a permissible five minute suspension of quotes if an unscheduled auction occurs).  Market maker quotes are also supposed to be refreshed each 90 seconds.

LTPX and XMHP fall within the narrowest spread band on the exchange, with bid and offer prices supposed to deviate by only 1.5% from each other, while IJPN has a 3% maximum spread.  That there’s a difference in the maximum spread bands for these three funds may seem surprising, since all three track the same underlying asset class.  The choice of band is down to an issuer when listing a product, said the London Stock Exchange, and reflects that issuer’s perception of the liquidity of the underlying market.

There are get-out clauses for ETF traders: market making obligations can be lifted should no firm price be available for 10% or more (by weighting) of the index on which the ETF is based, and should a significant event occur, such that for any underlying constituent no price is available, then a registered market maker can request to have the maximum spread regime temporarily suspended.

On the face of it, of the three funds surveyed, only the market makers in IJPN met the LSE’s obligations during the week concerned, at least if spreads are averaged over each minute of the trading day: the highest bid-offer spread recorded for the fund was 286 basis points, recorded for three successive minutes in the afternoon of March 15.

LTPX, meanwhile, recorded lengthy periods of time when bid and offer prices were missing altogether at the London Stock Exchange; and when prices returned to the order book on Wednesday and Thursday, spreads exceeded the maximum 1.5% for large periods of time.  XMJP, db x-trackers’ MSCI Japan ETF, also saw spreads exceed the 1.5% maximum for much of the week.

Questioned by about last week’s events, a spokesman for the London Stock Exchange stated that “market makers are obliged to quote prices throughout the trading day. There are rules that allow market makers not to quote in certain circumstances, and there is a short period if they delete their quotes or have an execution before they have to re-enter their quotes. We cannot comment on individual conversations that we have with our market makers. However, if market makers continually do not meet their obligations, we would in the first instance work with them to understand their issues in order to resolve them. If that fails, we do have disciplinary procedures that we could follow if we felt this was appropriate.”

In practice, said one specialist trader in ETFs, all European exchanges recognise that market makers may not be able to fulfil their obligations from time to time, and so the rules on maximum spread and the requirement to quote continuously are not rigorously enforced.  “If market makers cannot quote, they will not do so,” said the trader, “and European exchanges will typically allow them leeway not to quote in certain circumstances.”

Lyxor’s deputy head of ETFs, Nizam Hamid, pointed to the high volatility of the Japanese market, the fact that LTPX had a single market maker, and to the ETF’s tight trading band in its LSE listing as reasons for the periodic absence of market quotes in this fund.

“The recent unfortunate events in Japan have triggered extraordinary volatility in the Japanese stock market, and consequently in the TOPIX index, tracked by the Lyxor ETF Japan (LTPX),” said Hamid.

“This extremely high volatility made it very difficult for market makers to maintain their quotes. In the specific case of LTPX, which is listed in London, the situation has been made even more difficult as Société Générale (SG) is the only official liquidity provider on the product,” he continued.

When the market entered a severe downturn on Monday 14, explained Hamid, the fund’s market maker decided to suspend quoting, as it felt that that maintaining spreads within the permissible 1.5% band could have caused mistrades that would have been detrimental both to the market maker and to end-users.  The LSE’s quoting rules – specifically, the absence of a fast market mode on the exchange, the 1.5% maximum bid-offer spread band and the 5% deviation from the last recorded price for a mistrade to be declared – made it difficult for market makers to quote continuously in London throughout the post-tsunami events, Hamid added.

During the week, SG’s market making team “maintained quotations on NYSE Euronext Paris, Borsa Italiana, Spain, SWX and Xetra on ETFs this specific market exposure (TOPIX),” he clarified.

It’s clear from the chart below that the French-domiciled version of Lyxor’s Topix tracker (JPN) traded throughout the week on the NYSE Euronext Paris exchange with substantially lower spreads than the London-listed LTPX.  JPN is much larger than LTPX – it has over €500 million in assets, compared to LTPX’s £10 million – and it has five official market makers, compared to the single one operating in London for LTPX.  Lyxor’s German and Italian listings of JPN also have five official market makers, said Hamid.

Manooj Mistry, head of ETF structuring at db x-trackers, said that his firm’s MSCI Japan tracker,  XMJP, is also supported by only one official market maker (db x-trackers’ parent company, Deutsche Bank) in its London listing, compared with four market makers in the main, Frankfurt listing of this ETF. XMJP is the most actively traded Japanese equity ETF on the German Stock Exchange.

“London Stock Exchange spreads for XMJP during the last week were wider due to the high volatility in Japan, but they have returned to normal levels this week,” said Mistry.  Questioned about the periodic spikes in XMJP’s bid-offer spread to above 10%, Mistry commented that “these were not price quotes from Deutsche Bank's market making desk.  We may have temporarily been out of the market for a few seconds so another (non-official) market maker could have had a wide spread at that time.  Our internal analysis showed that the fund’s average spread on the LSE was around 75 basis points last week, whereas the average for the previous week was 30 b.p. and, for the week before that, 29 b.p.”

It therefore appears that the number of market makers supporting a particular ETF has a direct correlation with the ability to maintain tight spreads in volatile markets.  So why don’t issuers insist that more market makers are in place for each fund?

It’s not a foregone conclusion that traders will sign up on an exchange to quote buy and sell prices in a particular ETF, said two issuers contacted by they may have to be incentivised to do so.  According to one trader, there’s also a subtle difference between an “official” market maker in an ETF and an “appointed” market maker: the former may be there in name only, but not necessarily quoting competitive prices, while an appointed market maker signs an agreement with the issuer to keep tight quotes in particular ETFs (and is usually paid to do so).

The events of the last week raise a series of concerns for those investing in exchange-traded funds. There are clearly potential difficulties in pricing funds when the underlying market is closed (as Japan’s market is for the whole of Europe’s trading day). There can be significant differences in trading costs between different listings of a single fund, or between different fund structures tracking the same index.  European exchanges can have very different rules in place when it comes to ensuring the sustainability of quotes during periods of market upheaval.  The more official liquidity providers there are for an exchange-traded fund, the better, according to the week’s evidence.  And, as was illustrated in the flash crash last year, if you use market rather than limit orders to trade, you risk incurring dramatic costs when spreads widen.

Whether the average investor is equipped to take decisions in all these areas is arguable.  It appears that – well beyond its primary impact on the lives and livelihoods of millions of people - Japan’s tsunami has also raised major questions over the tradeability of ETFs.

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