Despite Europe being much smaller than the US, the changes to the European ETP market are likely to be far more dramatic and, despite scale, the main difference between these two major ETP markets is their structure.
A developing world
The expected themes for the European ETP market for 2013 and beyond include product structure changes, provider consolidation and rising competition/fee pressure in the core product offerings. Overall, we believe the European market will increasingly move to resemble the US market, with assets managed by the current large bank providers increasingly gravitating to the large institutional players; the innovation that the banks have brought to the space will be taken over by the emergence of specialist providers.
The structural changes in the ETP market are largely being driven by investor perception that physical replication is preferable to synthetic (swaps) and that they own an asset where physical replication is employed and they own bank risk where swaps are used.
There can be a very in-depth debate to be had here but it would take far longer to explain than this article would allow! It is safe to say that both methods have their pluses and minuses, but overall the ETP structure is arguably the most robust model available in the asset management world, irrespective of method.
However, the banks seem to be losing the argument. The conclusion will be that the core products will gravitate to physical and where physical cannot be used or is not efficient then swaps (with collateral for counterparty protection) will be adopted. There are sub-arguments around physical funds lending assets, but the main trend will be as stated. We have already seen announcements from banks stating they will offer physical replication within their offerings suggesting they can see the writing on the wall.
The second structural change will be that regulators are likely to pressure bank providers to accept the majority, if not all, of their swaps from third parties. It seems like throwing the baby out with the bathwater to not allow ETPs to use swaps, especially where physical does not work or is not efficient.
What does seem sensible is for the provider to get their swaps from a third party and therefore not concentrate their risk all within the same company and potentially across multiple counterparties, i.e. more than one bank. The most powerful feature of this model is that a provider can change counterparties at any point if it is the best thing for the investor. This decision becomes independent of any conflicts of interest – including the so-called independent model – but the majority of ownership is still an investment bank or a group of investment banks. I would bet that many bank providers today would love to replace their in-house swap for a third party, but that’s admitting defeat!
It is very likely that further fee and revenue compression will be seen by providers fighting for the core product provision. The large AUM products such as FTSE 100, Eurostoxx 50, Dax etc. will be a race to the bottom for all providers. With the European Securities and Markets Authority also telling physical-replication providers to return stock loan fees to the fund then this fight will get bloody. However the investor should benefit through lower fees.
The results of these structural changes will in the medium term lead to consolidation. Credit Suisse’s ETP business being sold to Blackrock is just the start. You will also see many funds closing as it becomes clearer the world does not need 20-plus Eurostoxx50 ETPs.
For the UK ETF market specifically, the major challenge for providers and the biggest driver to change is going to be RDR that essentially should change the way financial advisers work as they move to the fee-based model.
Currently, ETPs have made limited penetration into the UK retail market, but RDR should change this. It will take time for RDR to gain traction and find its equilibrium, but over time intermediaries will see more and more reasons to use ETFs within an asset allocation model. This has been the result in the US, but expectations need to be tempered as it has taken a long time to get there.
So what next?
What has not been seen too much is the emergence of the independent, niche players as seen in the US where 40-plus providers exist. There have been some European success stories in ETF Securities and Source. ETFS has been an unbelievable success in the commodity space and Source has had some success in the sector space and some other niche ranges. Source however is somewhat of a hybrid utility, independently managed but owned by a panel of banks.
It does seem that a logical evolution is for specialist new players to emerge and take the place of the banks as they retrench further. This will especially be the case for innovative and non-core products.