Anthony Malakian: Remember, the ETF Space is Still Evolving

Talk to almost anyone who deals in the ETF space and they'll sound a bit like an evangelist. This is especially true when it comes to fixed-income ETFs. They take their time to explain these products and their underlying benefits. They tend not to get too deep into jargon and they use examples to illustrate their ideas.

The evangelism is perhaps spawned because in the fixed-income market, ETFs are still a relatively new offering when compared to their equities counterparts. It's like a poker player trying to build the pot before showing his competitor the full house he built on the river.

The head fixed-income ETF evangelist is Reginald Browne, but everyone calls him Reggie and he's known as the "Godfather" of ETFs. After building ETF desks at Newedge and Knight Capital, Reggie and his team have moved on to Cantor Fitzgerald, where Browne serves as the global head of its ETF group.

But even as an advocate, he acknowledges that there are still issues that need to be addressed. While not a heavily regulated space, ETFs are required to have a lead market-maker (LMM). These firms provide pricing—and this is a difficult proposition in fixed income—and are expected to commit capital to generate liquidity in a newly launched product.

Enter the Godfather
It's Browne's job to drum up business, so he's clearly got a dog in this fight as he's trying to turn Cantor's ETF operations into a power on the Street. Browne thinks that investment banks are going to face increasing competition from asset managers in the coming years. Pensions, endowments and hedge funds have started to entered the fixed-income ETF space, which has helped grow the industry from a retail-driven outfit of $20 billion in 2006 to an ever-growing vehicle of over $300 billion today. But their roles may change.

"Over the next three years, I think you're going to see a number of asset managers launch ETFs and they're going to launch fixed-income ETFs first because that's the largest opportunity set," Browne says. "The opportunity is around sector fixed income, which is still not in ETF format. When you think about equity ETFs and how there's a ‘smart beta' structure out there and apply that to fixed income, we don't really have that yet. So, will the sell side rise to the challenge and launch products as LMMs? Being an LMM is challenging from a margin perspective, so I don't see many firms gearing up to take on that role. That will remain a weakness for the industry to solve."

Market Structure
Equity ETFs have been around for decades, but it has only been since 2007 that fixed-income ETFs have become more diverse, both in terms of product offering and in operators distributing these investments. When times are good, it's easy to be an LMM, but how about when the seas are turbulent?

Robert Smith, president and chief investment officer at Sage Advisory Services, says the fixed-income market has become extended in terms of market-makers being able to support the inventory relative to the size of the business. He argues that capital constraints created by the Volcker Rule (and Dodd-Frank) and Basel III in Europe have created frailties that will need to be addressed. Smith adds that the current regulatory environment allowed the underlying cash market to remain unaffected, but due to capital constraints, market-makers are unable to carry as much inventory as before.

"The regulators over-extended their reach and over-constrained the Street, but let the market run in terms of its growth—it's lopsided," Smith says. "In an elevator in a 30-story building, if you started to fall, the brakes used to kick in after 10 stories. Sure, it was uncomfortable, but you stopped. Now, those breaks aren't going to kick in until later—if at all."