With an eye on new revenue opportunities, sell-side firms are launching trading desks for exchange traded funds, a global market that has close to $3 trillion in assets under management. Investors have been pouring money into ETFs, as they offer low fees, exchange trading and exposure to different countries, regions and asset classes. While sell-side firms want to jump on the ETF bandwagon, they can’t enter the business without the right infrastructure and functionality. But the technology requirements are forcing some banks and brokers to examine the fitness of their order management systems for handling ETFs.
Banks and brokerage firms running legacy OMSs are finding that they pose an obstacle to entering the ETF business as authorized participants. These internally built systems are proprietary, expensive to maintain, and missing functionality that is required for proper ETF trading. It’s a situation that can put firms in the awkward position of having to turn away business.
Why Are ETFs a Good OMS Opportunity?
In the past two to four years, several brokerage firms and authorized participants have started new ETF trading desks, reflecting the popularity of this vehicle. While there are many kinds of ETFs, passive ETFs make up the bulk of the class since they mirror the composition of index funds, which can be based on stocks, bonds, currencies and commodities. Among the most liquid ETFs are the SPDRS (known as SPYs) based on the S&P 500 stock index, Diamonds (DIA) based on the Dow Jones Industrial Average index and the Qubes (QQQ) based on the Nasdaq 100 index of stocks.
The move into ETFs is driven by broker dealers seeking to facilitate orders for institutional clients, such as portfolio managers, who utilize ETFs to gain exposure to an index or as part of rebalancing. Also, as revenues have declined in traditional equities, brokerage firms are shifting to other types of trading products, such as ETFs, which give them a variety of ways to trade the securities and the underlying cash components as baskets. These ways include:
- In both an agency and principal capacity;
- Trading in the underlying baskets and executing against client orders in ETFs;
- Converting ETFs into baskets of securities and, vice versa, converting baskets into ETFs through a process known as creation/redemption;
- Trading futures in conjunction with the ETFs and baskets;
- As arbitrage opportunities between the market value of the ETF and the net asset value (NAV) of the fund;
- Capturing the price differential between the market value of the ETF funds and the components, which are baskets of securities.
The FlexTrade Solution
Some sell-side institutions that operate a legacy OMS have seen this as an opportunity to launch their own ETF trading business using FlexTrade’s FlexOMS ETF platform. In other cases, investment banks that were already using FlexTrade’s multi-asset FlexOMS on multiple desks, such as cash equities, program trading and market making, wanted to expand their offering to include ETFs. After hiring new talent and looking for new systems, many realized that FlexTrade had the breadth of functionality that their desk required. In addition, some banks operating separate OMSs for ETFs and basket trading found that FlexTrade is able to streamline and integrate all of the functionality into one system, thereby eliminating the need for two.
Three Driving Factors of the Sell-Side
From the sell-side’s perspective, three factors have driven their projects: First, there’s a desire to reduce costs associated with an internal development team. Banks see a chance to outsource the technology, thereby reducing costs and speeding up time-to-market. Second, banks need certain ETF functionality to attract business from institutional clients. Third, banks are out to grow the business, which will be easier to do on the new platform.
How FlexOMS ETF Works
One of the strengths of FlexTrade is the ability to interface with internal systems. FlexTrade works very closely with clients to integrate the OMS into their internal systems. In several cases, FlexTrade’s integration of FlexOMS ETF into a bank’s systems, covered:
- Inbound and outbound FIX connections
- Compliance, mid-office, back-office systems, reporting
Since each broker dealer/bank takes a distinct approach to the ETF business, FlexOMS ETF is configurable for each client’s requirements. Each client is given templates which they can choose from or further customize.
There are multiple ways to trade ETFs and different ways that order flow enters the OMS. Orders can automatically flow into the main order blotter via the FIX Protocol or traders can manually enter client orders. Because of the way ETFs are traded, FlexOMS ETF was designed to accommodate single stock trading or baskets of stocks. Like a mutual fund or an investment fund trust, the ETF can be bought or sold at the end of the day for its net asset value or NAV. However, the ETF can also be traded intraday.
The main screen, known as Risk View, provides NAV, Bid/Ask and P&L. Traders also use Risk View to monitor their positions in ETFs and baskets. The Delta calculation provides the real-time exposure across the traders ETF, Basket, and Future positions. Drawing on its background in program trading, FlexTrade provides ETF traders with tools for calculating the net asset value based on a real-time basket to allow a trader to compare the equivalent ETF price of the Basket and Futures to the ETF price.
When facilitating client orders, banks or brokers are able to buy ETFs and sell baskets of the component securities. Conversely, they can buy the baskets and sell the ETFs. Brokers can also act as market makers publishing bids and offers in ETFs on the open market. Each day, banks need to be informed of all the ETF components and their weightings. FlexTrade obtains this data feed from the Depository Trust and Clearing Corp., and uploads it to the OMS each morning.
Create and Redeem
Large broker dealers – known as authorized participants – can enter into agreements with the ETF’s distributors that will create ETFs in exchange for the Baskets or redeem Baskets in exchange for the ETF’s. The creation/redemption process is conducted in “creation units” which is generally 50,000 equivalent ETF shares.
Rebalancing is an important feature of trading ETFs to ensure that the basket replicates the composition of the ETF. Banks will not always have the perfect basket, so they often need to rebalance the basket which also can include cash.
Another key aspect of ETF trading is around compliance. Firms must ensure that they are compliant and have proper audits, controls and procedures in place. This is the key to OMS functionality. Also, from a systems perspective, it becomes the service bureau’s responsibility to ensure that the “ever changing” regulatory requirements are integrated into their systems.
Lastly, because traders are required to obtain the best price in the market, FlexOMS ETF uses its smart-order router to send intermarket sweep orders (ISOs) to take out liquidity from other venues, which are protected market centers under Regulation NMS.
By outsourcing their OMS to FlexTrade, banks have saved costs and closed the gap on their ETF functionality. Some dealers are actively managing a few hundred ETFs (domestic and international) across 4000+ securities on the FlexTrade platform. Leveraging the flexibility and multi-portfolio trading capabilities of the platform, dealers can optimize the position and transaction cost management across multiple ETFs with overlapping constituents.
As banks look to diversify trading desks and generate profits, the explosive growth of ETFs is a niche that appeals to many financial institutions. But before they can enter the ETF ecosystem, sell-side firms will need an OMS that can handle ETF-specific functionality as well as grow the business. At the same time, launching a new desk can also shed light on the economics of running legacy systems. Firms that are locked into proprietary OMSs are spending millions of dollars per year supporting aging systems that cannot expand easily. As the ETF landscape continues to evolve, sell-side institutions will want an OMS with sophisticated ETF functionality that incorporates basket trading and all the calculation engines and analytics. Banks and brokers that make the move will gain the competitive edge.