ETF Capital Markets Desk: Making Market Orders Better

Some possible ideas to make market orders work as they were originally intended.

    David Mann

    David Mann Head of Global ETF Capital Markets,Franklin Templeton

    David Mann, our Head of Global ETF Capital Markets, argues that the definition of “market order” has changed over time. He proposes some possible ideas to make market orders work as they were originally intended.

    I had been planning a brief update on my original bid/ask spread misconceptions post, but wound up with a three-part series. I guess there was more to explore than I originally thought! See parts one and two if you missed them.

    In my last post, I discussed how the definition of “market order” has changed over time. For this effort, I am going to propose some possible ideas to make market orders work as they were originally intended (with no regard to how difficult these ideas might be to implement)!

    1) Make market orders smarter

    The original spirit of a market order is to allow an investor to buy or sell their shares based on the current market price. Market makers are often more than willing to trade far more size than is shown on the bid or offer. The main reason they do not show that extra size is to limit the amount of capital they are risking across the thousands of ETFs they are trading at any one time.

    So here’s my idea: Why not just turn a market order into a “smart market order” behind the scenes by adding a limit price that is set at a predetermined amount above/below the current best bid/best offer? This amount would be based on conversations between market makers and the ETF issuer.

    For example, let’s say there is a new ETF that only holds US underlying stocks. The spread is typically five cents wide ($35.50 x $35.55) with 1,000 shares of size on both the bid and the offer. After discussions between the market makers and ETF issuer, the offset amount is set at three cents.

    An investor sends in a market order to buy 3,000 shares. Today, the investor would buy 1,000 shares at $35.55, and the other 2,000 shares would trade at some higher price. This could be a penny higher, or a nickel higher, or a dime higher—or even a dollar higher. It all depends on who else is offering stock and at what price.

    The “smart market order” would turn this market order into a limit order to buy 3,000 shares at $35.58. The investor would still buy the first 1,000 shares at $35.55. If there were 2,000 combined shares offered at $35.56 or $35.57 or $35.58, then the trade would be no different than the original market order.

    However, if there are not enough shares offered, then the limit order to buy will stay in the market at $35.58 for the remaining balance. The expectation is that the trade would be completed at this price given the offset was determined based on market maker feedback.

    The investor wants to buy at market levels. The market makers and ETF issuers think that current market levels should not go higher than 3 cents away from the current offer. This order type makes sure that is the case.

    2) Bring back floor specialists

    The New York Stock Exchange is taking steps to allow ETFs to list on the NYSE floor instead of NYSE Arca. I am very curious to see how this listing option will fit into the current market structure and whether it could solve today’s issues with market orders.

    3) Send the remaining balance of the order to the exchange’s designated market maker

    This is a combination of the first two suggestions. The market order executes as many shares as possible at the current best offer in the market. The remaining balance would get routed to the listing exchange’s designated market maker who would then complete the order. This option also gives an additional incentive for firms to serve as the main exchange liquidity provider.

    Whether it is sending the order to a specific firm or adding a limit based on the current market, the outcome is improving the indiscriminate nature of market orders that seek liquidity at any price—that technically would buy at infinity and sell at 0.

    Investors can once again submit market orders and have confidence they will get filled at the appropriate market levels.

    The comments, opinions and analyses expressed herein are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.

    This information is intended for US residents only.

    What are the Risks?

    All investments involve risks, including possible loss of principal. For fixed income funds, bond prices, and thus a fund’s share price, generally move in the opposite direction of interest rates. Special risks are associated with foreign investing, including currency fluctuations, economic stability and political developments; investments in emerging markets involve heightened risks related to the same factors. To the extent a fund focuses on particular countries, regions, industries, sectors or types of investment from time to time, it may be subject to greater risks of adverse developments in such areas of focus than a fund that invests in a wider variety of countries, regions, industries, sectors or investments. Performance of the funds may vary significantly from the performance of an index, as a result of transactions costs, expenses and other factors. These and other risks are discussed in the fund’s prospectus.

    ETFs trade like stocks, fluctuate in market value and may trade at prices above or below their net asset value. Brokerage commissions and ETF expenses will reduce returns. ETF shares may be bought or sold throughout the day at their market price, not their Net Asset Value (NAV), on the exchange on which they are listed. Shares of ETFs are tradable on secondary markets and may trade either at a premium or a discount to their NAV on the secondary market.

    For more information on any of our funds, contact your financial advisor, download a free prospectus or call us at (800) DIAL BEN/342-5236. Investors should carefully consider a fund's investment goals, risks, sales charges and expenses before investing. The prospectus contains this and other information. Please read the prospectus carefully before investing or sending money.