Archive for May, 2009

ETF Seed Capital Revisited May 2009

There has been an increasing incidence of new ETF issues being unable to come to market because no Market Maker sees to fit to put in for the allocation of the product.
The question is whether the lack of an interested Market Maker occurs because the prospective product has little or new merit or is there another possible explanation.
A quick analysis of the roughly 30 products that have launched in 2009 indicated that most have been fairly successful. The lack of interest in new products therefor would appear to be for other reasons.
Historically, Market Makers have provided the initial seed money to bring shares to market, much like an equity IPO. The reward for becoming the Lead Market Maker, or Designated Market Maker was a slightly larger liquidity payment on an electronic platform(ARCA or NASDAQ). If listed on the AMEX, prior to its sale, the advantage was that fewer Market Makers could easily trade no Specialist(LMM) products if the MM was also a Specialist on the AMEX.
With the demise of the AMEX floor, all ETFs are now traded totally electronically with the volume split between NASDAQ, ARCA and DirectEdge in descending order of volume. The net result is that there is little advantage to being a Lead Market Maker other than the 10 cent additional liquidity payment an LMM receives from ARCA. The risk is that the new issue will sell slowly resulting in the LMM having money tied up in seed with its consequent cost.
The result is that many Market Makers are telling Issuers that they will gladly trade their products if they sell quickly and show good daily trading volume but have little or know interest in tying up capital in seed.
The result is that good potential products may not make it to market hurting both Issuers and investors.
This situation has become compounded by the enforcement of an ARCA rule which requires an LMM to maintain certain levels of participation or losing the product and the additional liquidity payment. If the product is a slow grower the LMM gets to keep it with the consequent seed commitment. If after a short or long period of time the product becomes active and successful, the LMM who made the initial commitment runs the risk of losing the LMM designation and the liquidity payment kicker.
The response of the Market Maker-why provide seed? Just trade the ones that are successful with high volumes.



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