THE ON-EXCHANGE ETF RFQ MODEL.
What’s in it for institutional investors, asks Massimiliano Raposio, Market Hub, Banca IMI.
In this article we review the ETF RFQ execution model, as promoted and managed by the primary exchanges, and assess whether it provides an attractive solution for institutional investors. We also ask where the model sits in the industry in comparison with risk pricing and the RFQ services promoted by the major electronic trading platforms and venues? In addition, can on-exchange ETF RFQs become increasingly relevant for the needs of institutional investors?
This examination is by no means systematic, as it is based primarily on the characteristics of the ETF RFQ service offered by the Italian exchange, Borsa Italiana. As a member of the exchange, Banca IMI’s Market Hub, has provided access for its clients since its December 2016 launch.
Exchange Traded Funds (ETFs) now account for a substantial chunk of buyside investments with studies showing ownership levels by the asset management industry at between 30% to 40% of total assets.
When selecting a liquidity provider for ETFs, price competitiveness is regarded as the most influential factor for buyside institutions globally. This is also supported by MiFID II which emphasises the importance of the price discovery process.
Consequently for the buyside, RFQ processes have established themselves as the benchmark model for executing and as an alternative to seeking a risk pricing execution from an individual liquidity provider. The RFQ model which consists of a competitive auction process among counterparties, is typically conducted on institutional marketplaces, and through widely available electronic platforms, such as Bloomberg and Tradeweb.
In fact, the liquidity available on ETF instruments quoted on listed markets is inadequate to meet increased buyside requirement to trade immediately and with limited market impact. Some exchanges have addressed this trend by developing RFQ electronic platforms as part of their offering to complement the scarce liquidity available on their continuous trading segments.
Borsa Italiana was an early adopter, launching RFQs on ETFs at the end of 2016. The ETF RFQ order process has subsequently been enhanced with a number of tailor-made parameters, which aim to mirror those available through the electronic platforms. In parallel, the number of liquidity providers has increased.
An ETF RFQ order on Borsa Italiana can be submitted for orders above €100,000 and allows interaction with 10 market makers in either ‘manual’ or automatic execution modes. Buyside traders can choose for the RFQ to be anonymous (i.e. open to all liquidity providers) or visible (i.e. selecting up to eight competing market-makers). In addition, they can access this service through any broker member of Borsa Italiana’s ETFplus platform.
The flows processed via this channel are still small compared to institutional electronic marketplaces, but they are growing in both numbers of orders and size. In February 2020, Borsa Italiana recorded 442 trades, a new historical record, with a total turnover of more than €1.1bn. The average trade size in 2020 until end of February was €2.5m per trade, which points to an increased usage by local asset managers, private banks and insurance companies. Since the beginning of 2019, more than €12bn has been traded via this functionality.
The advantages of on-exchange RFQ orders
The main selling points for the exchange RFQ functionality are central counterparty (CCP) clearing and the access through their broker via an agency model rather than by establishing a direct relationship with a liquidity provider. The RFQ order-flow on exchange is fully incorporated into the equity execution workflow, and all executions settle against the executing broker, with CCP clearing, minimised risk and no settlement relationship with the dealer against which the transaction has been completed.
The advantages of the exchange RFQ can be summarised as follows:
- CCP clearing minimises settlement fails and improves efficiency as RFQ trades are automatically cleared and settled like on-book trades.
- The agency model separates commission from the best execution price and at the same time channels the flow within the standard equity workflow client-to-broker (including utilising the same connection).
- Anonymity (although the request can also be named).
- Limitation of counterparty risk and no requirement for onboarding or assigning a limit to multiple counterparties.
- Trades are made on a regulated market and reported and consolidated with the exchange volumes.
Focus on best execution
The requirement for best execution will continue to be an important driver for the development of on-exchange RFQ processes, as they become increasingly widely adopted. This can be measured in terms of size as well as pricing benefits of RFQ trading compared with centralised, top-of-book exchange-listed prize and size (BBO).
In order to analyse this point, we looked at the data made available by Borsa Italiana. In terms of trade size, the average ETF trade executed via RFQ on Borsa Italiana in 2019 amounted to 150 times the average trade size of orders executed directly on the exchange over the same period.
In terms of price, the average improvement spread over Best Bid and Offer (BBO) had ranged between 4.3bps and 8.9bps, depending on the category of ETF.
If we looked at all the trades executed in 2019, 88.2% were traded within the spread.
RFQ trading provides better access to liquidity, as well as more competitive and transparent pricing. This more efficient workflow also applies to on-exchange ETF RFQs and not only to the more established institutional platforms, because the workflow and the participants are comparable.
When looking at executing RFQs on-exchange instead of using the electronic platforms, which currently enjoy a bigger market share and a longer track-record in this service, there are several advantages. Given that the execution size and price is the same, institutional investors operate in a fully regulated market framework with CCP clearing which electronic platforms are only now starting to develop. In addition, they have the opportunity of integrating this service in a fully transparent agency model, available through their broker. This, in our opinion, is why they deserve the full attention of market participants.
*Details on how the service operates are available on the Borsa Italiana web-site: https://www.borsaitaliana.it/etf/rfq/rfq/rfq.en.htm