1. The make or break
of European ETFs
Due to the strong growth of Exchange Traded Funds (ETFs)
in Europe, market makers and traders are set to adopt
enhanced tools to trade these instruments and offer ever
more compelling reasons to take up a widening range of
products on offer. Inves-
tors now appear spoilt for
choice with ETFs, products
which allow exposure to a
whole index or sector - in
just one trade.
Originating in the US
with offerings on the S&P
500 (SPDRs) and the Dow
Jones Industrial Average,
ETFs in Europe have largely been playing catch-up to the
US market where these instruments account for some 25%
of overall trading. Still, asset growth in Europe has zoomed
to $140bn in 2008 from just $680mn back in 2000. And, last
year the region saw ETF product inflows of $74bn versus
$570bn mutual fund outflows. Looking further into the
trading activity of ETFs, we can see they equate for 32% of
all US equity trading volume and it has reached 9.1% of the
total European Equity market as of the end of April, an im-
pressive rise from a relatively modest 2.8% a year earlier.
It’s also interesting to see how the ETF volumes have risen
despite a general slowdown in
trading activity.
Growth in Europe has also
been buoyed by the fact that
ETFs do not fall within the
MiFID definition of ‘shares’.
Rarely a day now seems to
pass without the latest flavor
of ETF launching. They are
available on equity indices,
sectors and fixed-income and commodities like gold,
physically replicated to an underlying basket of constitu-
ents or via derivatives using swaps-backed ETFs.
Today, while the 701 ETFs offered in Europe compare
favorably with the US number of 697 (June 2009), it is esti-
mated that the instruments in Europe still only represent
about 1.5% (vs. 4.6% for US) across all investment assets,
Orc Software examines the European ETF market; looks at current
market requirements and key differentiators. Marketing Director
Christine Blinke gets the latest trends and future predictions of the
European ETF market from Lee Griggs, Managing Director and VP
Sales Orc UK, and Senior Product Manager Markus Kämpe.
It’s also interesting to see
how the ETF volumes have
risen despite a general slow-
down in trading activity.
”
“
Markus Kämpe (left) & Lee Griggs (right), Orc Software

2. including actively managed assets. The difference equates
to $300bn worth of ETFs.
With volumes growing and the ETF product range
continually expanding, market participants need to react
with speed and intelligence in how they price, quote and
control their positions and risk exposures. As fund provid-
ers have many new ETFs up their sleeve for release in
the near future these challenges will not go away. For
example, iShares, part of Barclays Global Investors, which
accounts for the biggest market share of ETFs in Europe
at 38.7% (Q1 2009), claimed this June that it was thinking
about “at least” 70 to 80 new categories.
Emerging trends in European ETF trading
As an ISV providing trading solutions for more than 20 years
Orc Software has seen a fair share of its customer base ac-
tive in the ETF market, and, as part of the core segments
for Orc Software, the company has followed the market de-
velopment closely. Lee Griggs, Managing Director Orc UK,
gives the European perspective: “In EMEA we are prob-
ably at a make or break point, there is increased focus
on trading ETFs and more and more firms are investing
in technology to better price and execute these products.
Currently there remains a
reluctance to push large
volumes through if liquidi-
ty isn’t obviously available,
net result is that the flow
will go to the primary mar-
ket (the components of the
fund/basket).” Griggs con-
tinues: “Having said that,
we start seeing cracks in
that reluctance with more
aggressive market partici-
pants increasing their ETF
trading activity. Our gut
feeling based on the indi-
cations we see in today’s
market is that it will turn
into a more general trend
where more aggressive participants increase their pres-
ence in European ETF trading with improved liquidity and a
more competitive market as a result.”
Looking at the development at specific exchanges,
the London Stock Exchange (LSE) currently has ten ETF
market markers. LSE has around 200 listed ETFs from
providers like BGI’s iShares. The value of ETFs traded on
the LSE rose to £34.7bn (€39.5bn) in 2008 and came in
at £12.2bn in for the first quarter of 2009 (2000: £1.3bn).
This year could see a 40% growth in the LSE’s ETF trading
volumes, if Q1’s 2009 number is matched over the next
three quarters. Last year’s numbers only make up 3% of
total value traded across the exchange group - including
Borsa Italiana (BIt), which posted ETF turnover of €46.6bn
in 2008 (€10.7bn: Q1 2009).
BIt’s ETF-Plus market, which currently has eight
market makers, offers 300 ETFs that are listed through
Milan. Hopes are high that further integration of ETF-Plus
on the LSE group’s trading platform later this year should
provide an extra boost.
ETF market making challenges
The increased number of liquidity pools following MiFID
together with improved liquidity in ETF trading mean
more opportunities for the market participants, but also
tougher challenges as the markets get more competitive.
They need to stay efficient and competitive, which means
continuously seeking to improve their trading activity.
A significant challenge in an ETF market making opera-
tion is to keep costs low and at the same time not restrain
the trading activity. Historically (and still) there are many
ETF market makers doing a lot of non-productive admin-
istrative work to keep ETF definitions up to date and gen-
erate accurate quotes to
send to the market. Most
of the times the exist-
ing market making set
ups are based on Excel
spread sheets or legacy
software, implying high
cost of ownership and
slim chances of working
efficiently and keeping
up with competition.
Griggs acknowledges
the efficiency aspect: “As
head of an ETF market
making operation you
cannot afford traders fo-
cusing on anything else
but the profit generating
market making activity. You need to be able to take on new
products or challenges without worrying about additional
costs often connected to using legacy trading solutions
built for the market making needs seen some years back.
When talking to these decision makers it is clear that this
is a major concern for them and they feel they need to
move away from those solutions to be able to get to the
profit levels they are looking for.”
Hedging is at the very heart of any successful market
making strategy and ETF market making is no exception

3. to that. “There’s a push for flexibility,” contends Griggs
when talking about the timing of hedge executions.“ Be-
ing able to define when to make a hedging decision within
a trading system adds value. So, how long do I hold the
position before looking to hedge or do I hedge it only if
the market moves in a certain direction? Market makers
build this knowledge over the years and if they can put this
trading intelligence into the trading logic in partial or full
automation, they increase their chances of staying on top
of the market and keeping their competitive edge.”
Timing of hedge executions is only one part of the
hedging strategy for a sophisticated ETF market maker.
In many cases there is also a choice of instrument to use
when hedging, where for example a CAC-40 ETF could
be hedged by using the individual stocks making up
that basket on, for example, NYSE Euronext Paris or an
alternative MTF venue such as Chi-X or Turquoise or even
the traded CAC-40 index futures. Depending on current
market prices and volumes the preferred instruments to
use for hedging might (and likely will) vary during the day
and market makers being able to make this decisions at
the time the hedge order is to be sent are likely to have a
significant advantage in a more competitive market.
Griggs finishes the discussion on the subject by saying:
“There is a lot to discuss and understand about hedging in
ETF market making, but putting it short; in a competitive
market you as a market maker need to have flexible low-
latency execution on the liquidity pools you want to stay in
front.”
Quote generation is another aspect of ETF market
making where market participants really have a chance
of increasing their likelihood of being successful. Having
the ability to flexibly adjust the prices being generated
adds further value to the market makers of ETFs. Griggs
comments “The ability to lean the quotes based on exist-
ing positions or view of the market is vital when pricing
ETFs. This can be done in very simple terms, by purely
adjusting the calculated result in percentage points, or
by an absolute offset. However, it’s also possible to adjust
the individual components of the basket composition
and as such calculate the ETF from these input valuation
prices, this allows single modifications to have an effect
on multiple products where the individual equity is part of
numerous fund definitions”
Legacy IT or Excel spreadsheets to price and quote
ETFs and some sort of FIX layer for market access clearly
is never going to be as fast as receiving market infor-
mation directly, making calculations and disseminating
quotes directly to the market in a server based trading
solution. The increased presence of low-latency algorith-
mic trading engines in the market also makes
it important for market makers to reduce la-
tency in their quote updates and at the same
time build intelligent safety mechanisms
into the market making logic for the market
maker to not get picked off in case the quotes
are, for some reason, off.
Griggs: “I really see this challenge as com-
pletely integrated with the other challenges
discussed. Even though the ETF market mak-
ers currently might be using different tools
for administration, hedging and quote generation there
is really no reason for why it should be like that, rather
they go hand in hand. I see requirements like; automation,
scalability, flexibility and low-latency; and my view on this
is that there are trading solutions capable of handling this
today; where ETF market makers can price, quote and
hedge a large number of ETFs in a flexible and efficient
way without relying on multiple or legacy software solu-
tions.”
Arbitrageurs to follow where liquidity goes
With an increa-
sed liquidity, the
ETF market is
likely to seriou-
sly attract pla-
yers from the
more advanced
market taking
segments.
Markus Käm-
pe, Senior Pro-
duct Manager
at Orc Software says: “Based on the interest from the Eu-
ropean market participants it is likely that the European
ETF market will build even better liquidity going forward.
In the US, where the ETF market already has good liquidity,
we know that there is significant arbitrage trading activities
and a not too daring prediction is that an increase in ETF
liquidity in Europe should allow arbitrage trading firms to
be more active in the ETF market than they are today. This
There is a lot to discuss and understand about
hedging in ETF market making, but putting it
short; in a competitive market you as a market
maker need to have flexible low-latency execution
on the liquidity pools you want to stay in front.
“
”

4. means we predict a surge for low-latency arbitrage solu-
tions in the coming years in the ETF space in Europe as a
result of today’s increased ETF market making activities.
On a more general note Kämpe continues: “The market
making and arbitrage trading segments have both seen a
significant focus on efficiency improvements and the ETF
business is no exception to that. Trading solutions requir-
ing a high level of manual interaction are replaced by so-
lutions based on flexibility in integration, automation and
trading logic. Together with the increasing need of low-
latency trading to stay competitive in the market we see
a trend among ETF market participants to opt for server
based algorithmic trading engines when building for the
future, regardless if we talk about the European or the US
ETF market.”
If the European ETF market is at a make or break for its
participants remains to be seen, but on a concluding note
Griggs adds: “I think it is clear that there will be some sort
of transition, whether it is driven by increased liquidity or
a need to simply improve efficiency to stay competitive in
the market. From our perspective, we feel that we are in
a good position to capture a significant part of the mar-
ket we expect will develop and we see the European ETF
market as an opportunity going forward.” 
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I think it is clear that there will
be some sort of transition, whether
it is driven by increased liquidity or a
need to simply improve efficiency to
stay competitive in the market.
“
”