The ETF BILD Project Presents its First Leadership Discussion Session

ETF veterans discuss implications of FINRA Rule 5250

April 2018

From time to time, ETF BILD has the opportunity to discuss a variety of issues and topics with prominent individuals in the ETF industry. In connection therewith, we seek comments from our readership resulting in a full and thoughtful discussion around the issues and topics vital to the ETF Industry.

Recently, ETF BILD sat down to speak with three prominent veterans in the ETF space to capture their insights on FINRA Rule 5250, Payments for Market Making, and its implications.

Joining us for the discussion:

  • Reggie Browne – Senior Managing Director of ETF Trading, Cantor Fitzgerald
  • Laura Morrison – SVP, Global Head of Exchange Traded Funds, CBOE Markets
  • Jim Toes – President and CEO, Security Trader Association (STA)

Background: FINRA Rule 5250 prohibits market makers who provide quotes and related services to companies that list their securities on stock exchanges from accepting any payments from such companies. Rule 5250 is designed for corporate securities listed by ordinary companies and intends to assure that the market maker acts in an independent capacity when publishing a quotation or making a market in such corporate securities. ETFs are dramatically different from ordinary companies and do not present the same concerns, primarily because their economic returns are derived from the corporate securities they own. The application of the rule to ETFs may be preventing a relationship between the ETF issuer and market maker that otherwise could be highly beneficial to the ETF product and investor.

Currently, FINRA is conducting a general review of its rule book and has asked for comments relating to modernizing Rule 5250, which was adopted prior to the existence of ETFs. The debate is centered on whether or not ETFs should be exempt from this rule.

ETF BILD: What’s your view of FINRA Rule 5250 (Payments for Market Making)?

Browne: I’m an advocate for exempting ETFs from the rule because it solves a couple of problems. The ETF industry, on a global basis, should be harmonized to minimize the use of different practices in different global market centers. Refinement of rules governing the investor experience in ETFs should be an ongoing priority. Reorienting the U.S. so that it looks more like Europe, where ETF sponsors could have a direct relationship with market makers for services rendered, helps ensure there is a level playing field over the services delivered while negating regulatory burdens. The result of a commercial relationship between the market maker and ETF sponsor would most likely improve the investor experience in thinly traded ETFs with measurable, tighter spreads.

Also, I would like to note that in Europe there are no rules written on payments by ETF issuers to market makers; it’s silent. In my view, European regulators should take a stance on the practice to test for conflicts and mandate transparency.

ETF issuers want better outcomes, more control and more say in product delivery and process.

Morrison: I believe that Rule 5250 should apply to corporate equities for good reason because of how prices are discovered for corporate equities but not to ETFs. ETFs are essentially derivatively priced, a process that is very different than the pricing of corporate equities. Currently, ETF issuers can create agreements with market makers in Europe and the results of this engagement have been positive, not for all issuers but for some. We see the value in the ability to do it here in the U.S.

Unfortunately, ETFs have been swept into all equity security rules without consideration for what makes an ETF unique. ETF issuers are asking for the ability to pay market makers. We are suggesting that issuers not be required to enter agreements for each and every product and market maker relationship, but rather giving the issuer the option to “pull this lever” on a case-by-case basis as they deem necessary or appropriate. Also, such ETF issuers could be required to disclose if an arrangement exists but not be required to disclose the dollar amount, length of the arrangement or specific requirements and expectations of the market maker. This would be helpful from a competitive standpoint.

Allowing such payments may result in the market maker being more engaged in their quoting commitments to the ETF product. The issuer’s investment up front could result in improved quote quality and price discovery for the end investor, which in turn may improve the issuer’s ability to attract assets in the ETF product.

Toes: If the rule were reformed, it would address certain existing barriers to entry for market makers in ETFs by enabling those firms to recoup some of the initial costs. Investors would still be protected from the harm that Rule 5250 addresses due to the arbitrage feature of ETFs and other unique attributes of the structure. There should be disclosure about these arrangements, which may cause the industry to become hung up on the amount of transparency and how market makers would react if they are asked to provide too much information around specific payments, but this could be sorted out.

ETF BILD:  The ETF industry is relatively small with a lot of competitive issues, so it’s hard for them to sit at the table together. Since the STA is a long-established trade association for individuals who trade equity and listed options, can the ETF industry and the STA work together to achieve common goals?

Toes: Here’s some background on the STA. We are comprised of 20 affiliates in the U.S., major cities with financial hubs, and four affiliates in Canada. We serve the trading community and engage in a variety of events; education, newsletters, open calls and conferences. We are a grass roots organization and spend a lot of time in [Washington] D.C. with the regulators and some legislators. We split time between the Senate Banking Committee, FINRA, U.S. Department of Treasury and the House Financial Services Committee.

It terms of ETFs, while this is a new area for us, we have established relationships with the trading desks and market makers for equities and options at firms who also maintain a presence in ETFs. Thus, we are able to leverage existing relationships to obtain new ones. As ETFs are becoming a more integral part of  market making activities, it is incumbent on STA to have an understanding of how they trade and issues impacting them. Rule 5250 is a good place for us to start.

Browne:  Yes, I think there is a role for STA representing the viewpoints of their members on issues impacting ETFs such as Rule 5250. ETFs are roughly a third of all volume on the equity exchanges, so it makes sense for them to take up some of these causes. So yes, the STA is a viable venue.

Morrison: Cboe has a close relationship with the STA, and their work with the trading community at large is something we welcome in a vibrant, cooperative marketplace at every level. Functionally speaking, ETFs are a source of huge liquidity and trading activity, and so it makes sense that the STA would offer their opinions on behalf of their members and our customers.

ETF BILD: Two last questions: (1) What’s your overall view on the effect of ETFs in the capital markets system; and (2) Are there risks of having the business be dominated by a few firms worrisome?

Browne: There is enough academic research on the topic about indexing, period. ETFs are only a part of the influence of price discovery and corporate equities. I don’t think there is a need for me to comment further. Those who are misinformed will continue talking about it.

There will be more asset managers launching their own ETFs, just like USAA and others, and an evolution will occur. But the football field-length start that iShares, State Street and Vanguard have is because they were first movers and they have done most of the work for the industry, so it is natural that they should be thriving.

Toes: From a systemic risk perspective, we’re not aware of concerns regarding the concentration or market share of the largest issuers. As we learn more about ETFs, we do see some areas of concern with the Authorized Participant or AP process. Phone calls, emails and other examples of lack of electronic connectivity can cause systemic risks. Go back to the crash in ‘87 when all trades were given via phone calls; electronic trading quickly began developing from that event.

Morrison: As for ETF risk in the capital markets system, more academic study and review is always welcome. This only helps expand on the educational efforts needed to support growth. Like many industries, the 80/20 Rule is also prevalent in the ETF issuer space, but that might not last forever. There are many large asset management firms expanding in the space either by organic growth or acquisition. While the U.S. remains in the lead in terms of ETF AUM and trading, we see a tremendous amount of opportunity for additional growth in our industry globally. Consistent attention by exchanges to proper market structure parameters for ETFs will enable that growth.

ETF BILD: ETF BILD and the organizations represented in these interviews have all sent comment letters to FINRA setting forth reasons as to why ETFs should be exempt from Rule 5250.

There are alternative views. One commenter raised concerns that an exemption for ETFs from Rule 5250 could lead to improper behavior in the market making community. It is that commenter’s belief that lifting the rule for ETFs might distort market forces, increase spreads by the market makers not being compensated, create a pay-to-play environment favoring those with more capital available to make payments and ferment an anti-competitive environment with exclusive arrangements.

ETF BILD believes that the concern about these issues should not prevent Rule 5250 from being relaxed for ETFs. In our view, these concerns can be easily addressed in FINRA’s rulemaking process of exempting ETFs from the rule.

Here is a link to all comment letters: http://www.finra.org/industry/notices/17-41

ETF BILD highly recommends reading all comment letters (they are relatively short) to get a full perspective on the issue. We also welcome all comments and to use ETF BILD’s website, LinkedIn and Twitter accounts to create an open, fair and respectful dialogue.

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