Exchange-Traded Funds, Liquidity, and Centralized Risk Books: Moving Liquidity beyond the Portfolio

Abstract

Since 1993, exchange-traded fund (ETF) product development has grown from broad-based equity benchmark indexes (i.e., S&P 500 Index) into a variety of asset classes and innovative, nontraditional index and active strategies. With this evolution, ETF issuers look to ensure that an ETF product lineup is supported by appropriate market participants. ETF capital market teams engage market participants (authorized participants and market makers) to understand each trading firm’s specific trading, hedging, and risk management processes. Based on the capabilities, the capital market groups select an appropriate lead market maker/designated liquidity provider. This selection process includes a market participant due diligence process. Given that ETF trading involves portfolios of underlying securities, capital markets teams look to engage with market participants using centralized risk books. Centralized risk books enable market participants to digest a variety of investment strategies into a well-diversified firm portfolio. Trading firms segregate centralized risk books across specific asset classes (US domestic equities, international equities, fixed income, commodities) as well as maintain oversight at a global level.