Exchanges and ETPs

The exchange-traded feature of ETPs is their primary advantage but what role do exchanges actually play?

If you’ve been around anyone in finance, or pay attention to financial news, you’re likely familiar with the New York Stock Exchange or the London Stock Exchange.

So what exactly is an exchange, and why do we care about them if we’re interested in exchange-traded products (ETPs)? After all, if you’ve only invested in mutual funds, you’ve likely avoided exchanges altogether.

In simple form, an exchange is a marketplace where buyers and sellers meet to negotiate prices to exchange goods.

When dealing with stocks and exchange-traded products, it’s a marketplace where investors put in orders through their brokers, who then send those orders to traders on the exchange floor—virtual or physical—to get those orders executed.

There are numerous exchanges throughout Europe where ETPs are traded, notably the London Stock Exchange, Deutsche Borse, NYSE Euronext Paris, Borsa Italiana and SIX Swiss Exchange.

At the exchange, various participants, including market makers—who are in the business of providing liquidity and promoting fair and orderly trading in securities—will quote “bid” and “ask” prices (see Understanding Liquidity).

Generally, most major exchanges are now electronic, and no longer rely on a specialist physically present on the trading floor shouting bid/ask quotes. Even the mighty New York Stock Exchange, one of the last to hold on to the specialist system, finally switched to an electronic trading platform in 2008. Still, the general concept is the same—buyers and sellers enter their best prices, and trades are made.

Financial exchanges are highly regulated and standardized marketplaces—one of their main benefits. Exchanges act as the intermediary that makes the seller and buyer whole on the price of the trade if one of the parties fails to fulfill its end of the trade.

Since ETPs are “exchange-traded”, exchanges stand at the center of their functionality. Unlike mutual funds, ETPs trade like stocks throughout the day during market hours. For UK-listed products, you can sell or buy an ETP whenever the London Stock Exchange is open for business.

The implication is that investors are subject to the costs of trading, such as bid/ask spreads and brokerage commissions charged for placing and executing the order (see Total Cost Of Ownership).

Exchanges also matter because they function as a screen—a kind of electronic bulletin board for products that trade there. Each exchange sets its own requirements to list on that exchange, such as mandatory minimum number of shares outstanding or minimum assets.

Exchanges compete with each other both for listings of products and companies and for investors. The more investors participate on the exchange, the fairer trading prices will be. Major players like the London Stock Exchange are generally significantly more liquid than smaller exchanges like the Oslo Stock Exchange. More liquidity generally equates to lower transaction costs and more accurate pricing for investors.

But liquidity is also an issue for the ETP’s underlying holdings. Where a fund’s underlying holdings are traded can impact the fundamental building blocks of how well the fund itself trades.

These differences, among others, ultimately determine which exchange the fund issuer chooses to list their product on. From the investor’s point of view, exchanges stand at the center of how ETPs work—and how they differ from mutual funds. Since many ETPs are available on multiple exchanges, you do have a choice.