This year’s rare midweek July 4 prompted a pause for the Market Structure Map to honor our Republic built on limited government and unbounded individual liberty. Long may it live.
Returning to our market narrative: Did you know that 100% of Exchange Traded Fund creations and redemptions occur in block trades?
In stocks, according to publicly reported data, three-tenths of one percent (0.03%) of NYSE trades are blocks (meaning 97.7% are non-block). The Nasdaq compiles data differently but my back-of-the-envelope math off known data says blocks are about the same there – a rounding error of all trades.
Blocks have shrunk due to market regulation. Rules say stock trades must meet at a single national price between the best bid to buy and offer to sell. That price relentlessly changes, especially for the biggest thousand stocks comprising 95% of volume and market cap (north of $2.5 billion to make the cut) so the amount of shares available at the best price is most times tiny.
We track the data. At July 9, the average Russell 1000 stock traded 13,300 times per day in 160-share increments. If you buy and sell shares 200 at a time like high-speed traders or algorithmic routers that dissolve and spray orders like crop-dusters, it’s great.
But if you buy cheese by the wheel, so to speak, getting a slice at a time means you’re not in the cheese-wheel buying business but instead in the order-hiding business. Get it? You must trick everybody into thinking you want a slice, not a wheel.
The cause? Market structure. Regulation National Market System, the regime governing stock trades, says one exchange must send to another any trade for which a better price exists there (so big exchanges pay traders to set price. IEX, the newest, doesn’t).
Put simply, exchanges are forced by rules to share prices. Exchanges cannot give preference to any customer over another.
ETFs get different rules. Shares are only created in blocks, and only traded between ETF creators and their only customers, called Authorized Participants.
I’m not making this up. When Blackrock wants more ETF shares, they create them in blocks only. From Blackrock’s IVV S&P 500 ETF prospectus: Only an Authorized Participant may engage in creation or redemption transactions directly with the Fund. The Fund has a limited number of institutions that may act as Authorized Participants on an agency basis (i.e., on behalf of other market participants).
Why can ETFs offer preference when it’s against the law for exchanges? Fair question. There is no stated answer. The unstated one is that nobody would make markets in ETFs if a handful of firms didn’t have an unassailable competitive advantage, a sure chance to make money (why ETF fees are so low).
Again from the IVV prospectus:
Prior to trading in the secondary market, shares of the Fund are “created” at NAV by market makers, large investors and institutions only in block-size Creation Units of 50,000 shares or multiples thereof.
Each “creator” or authorized participant (an “Authorized Participant”) has entered into an agreement with the Fund’s distributor, BlackRock Investments, LLC (the “Distributor”), an affiliate of BFA. A creation transaction, which is subject to acceptance by the Distributor and the Fund, generally takes place when an Authorized Participant deposits into the Fund a designated portfolio of securities (including any portion of such securities for which cash may be substituted) and a specified amount of cash approximating the holdings of the Fund in exchange for a specified number of Creation Units.
And down a bit further (emphasis in all cases mine):
Only an Authorized Participant may create or redeem Creation Units with the Fund. Authorized Participants may create or redeem Creation Units for their own accounts or for customers, including, without limitation, affiliates of the Fund.
Did you catch that last bit? The creator of ETF shares – only in blocks, off the secondary market (which means not in the stock market) – may create units for itself, for its customers, or even for the Fund wanting ETF shares (here, Blackrock).
And the shares are not created at the best national bid to buy or offer to sell but at NAV – Net Asset Value.
Translating to English: ETF shares are created between two cloistered parties with no competition, off the market, in blocks, at a set price – and then sold to somebody else who will have to compete with others and can only trade at the best national price, which continually changes in the stock market, where no one gets preference and prices are incredibly unstable.
It’s a monopoly.
Two questions: Why do regulators think this is okay? The SEC issued exemptive orders to the 1940 Investment Company Act (can the SEC override Congress?) permitting it.
We wrote about the enormous size of ETF creations and redemptions. Which leads to Question #2: Why wouldn’t this process become an end unto itself, displacing fundamental investment?