The impact of multilateral trading facilities on price discovery: Further evidence from the European markets

• Author: Mike Buckle,Xiaoxi Li,Jing Chen,Qian Guo
• Published date: 01 November 2019
• DOI: http://doi.org/10.1111/fmii.12121
• Date: 01 November 2019

DOI: 10.1111/fmii.12121

ORIGINAL ARTICLE

The impact of multilateral trading facilities

on price discovery: Further evidence from

the European markets

Mike Buckle1Jing Chen2Qian Guo3Xiaoxi Li4

1University of Liverpool,Chatham Street,

Liverpool L69 7ZH, UK

2Cardiff University, SenghennyddRoad, Cardiff

CF24 4AG,UK

3Birkbeck College, University of London, London

WC1E 7HU, UK

4University of Swansea, Singleton Park,Swansea

SA2 8PP, UK

Correspondence

XiaoxiLi, University of Swansea,

SingletonPark, Swansea SA2 8PP,UK.

Email:dr.xiaoxili@outlook.com

Abstract

This study examines relative price discovery for three major

European indices, FTSE, CAC, and DAX, their futures and exchange

traded funds (ETFs) using the data on 5-minute intraday transaction

prices overa four-year period. We computed both Hasbrouck (1995)

information share with error bounds and Gonzalo and Granger’s

(1995) common factor weights approach. Gonzalo and Granger’s

(1995) common factor weights suggest the index futures contracts

play a dominant role in price discovery in the CAC market: the

CAC 40 index futures lead the price discovery and Lyxor CAC 40

ETFs serving the second resort for information transmission. This

could be due to the less frequent trading of ETFs. More importantly,

CAC40 under the Gonzalo & Granger (1995) test shows upper and

lower error bounds in good range may be the main reason to drive

for the meaningful results. In contrast, the upper and lower bounds

estimated from the Hasbrouck (1995) are far distant for most cases.

Finally, FTSE and DAX markets offer compelling evidence to show

that ETFs lead price discovery and spots and futures follows.

KEYWORDS

common factor weights, exchange traded funds, information share,

price discovery

1INTRODUCTION

Nearly a decade after the financial crisis in 2008, exchange traded funds (ETFs) have become highly active and has

resumed its significance in the financial market, especially its price discovery function. This is primarily due to their

nature as highly flexible multilateral trading facilities, which enable diversification and hedging, and eventuallyeffec-

tive and efficient investment decisions for economic agents. One example of this emerged during the Fukushima

c

2019 New YorkUniversity Salomon Center and Wiley Periodicals, Inc.

Financial Markets,Inst. & Inst. 2019;28:321–343. wileyonlinelibrary.com/journal/fmii 321

322 BUCKLE ET AL.

nuclear disaster in 2011. While the home market in Tokyowas shut down, the Japanese ETFs listed in the U. S. contin-

uedto trade.1Consequently, it eased investors’ tension and reversed their tremendous potential loss through adjusting

investment portfolios in response to alterationsin this disaster of radioactive leak.

In Europe, the demand for ETFs has never been higher as witnessed presently, and European ETFs tend to

be multilateral traded simultaneously in London, Frankfurt, and Paris. Compared to mutual funds, ETFs have

clearly become more preferred investments because it is flexible, extremely liquid, low-cost and offers pricing

transparency. According to ETFGI, a London-based independent research and consultancy firm, ETFs managed in

Europe reached a record high of US$571 billon2at the end of 2016. A year later, this value amounted to as

high as US$777 billon, increased by a record US$206 billion approximately.3,4 BlackRock predicts European ETFs

under management will reach the amount US$1000 billion by the end of 2020. Currently, European ETFs are

largely owned by institutional investors and retail investors’ adoption of ETFs is a crucial ingredient that is still

missing.5

The European ETF market entails a highly fragmented marketwith multiple trading venues and listings. According

to ETFGI, at the end of December 2016, there were 6,976 listings from 56 ETF providers across 25 exchanges in 21

countries. The main European ETFs such as DAX, Euro Stoxx 50, Italy’s MIB, France’sCAC 40, and the pan-European

STOXX50 index operate in some of the most liquid markets. Given the current boom and major growth in ETF trading

in Europe, the need for research addressing the impact of the introduction of new instruments on the existing price

discovery structure is urgent.

Recent academic literature on price discovery seem to havelittle concentration on the emergence of new financial

instruments of this kind (see, for example, Chan, 1992; Choi & Subrahmanyam, 1994; Chu, Hsieh, & Tse,1999; Flem-

ing, Ostdiek, & Whaley,1996; Pizzi, Economopoulos, & O’Neill, 1998; Shyy, Vijayraghavan,& Scott-Quinn, 1996; Stoll &

Whaley,1990; Theissen, 2012). The majority have focused on the role of price discovery between futures and spot mar-

ketsand the general consensus is that futures market often dominates.6The traditional view of the lead and lag type of

studies suggest that the strong price discoveryamong financial assets is rooted in three basic aspects: low trading costs

(e.g.Chan, 1992; Fleming, et al., 1996), risk diversification (Deville, Gresse, & De Séverac, 2014; Gammil & Perold, 1989;

Subrahmanyam, 1991) and sufficiency together with synchronization of trading (Chan, 1992; Chou & Chung, 2006;

Shyy et al., 1996; Stoll & Whaley,1990; Theissen, 2012). ETFs, which are designed to replicate the performance of an

index as closely as possible (Hedge & McDermott, 2004) through a single instrument/fund of a basket of securities,

demonstrate excellence in all these areas. However, literature show varied results that stock futures still overpower

ETFs in many cases. For instance, Frommherz (2017) argues that futures and ETFs of DAX are found in a contesting

relationship: the stock index futures market still takesthe lead and it was closely followed by the ETF; but the level of

dominance of futures was weakenedby the ETFs contribution to price discovery. Additionally, tradingof the ETF led to

the close alignment of share prices of the underlying components of DAX. This means the price gap between the ETFs

and underlying stocks were tightened more than that between spot and futures.7,8 Therefore, the important and natu-

ral question to ask is whether proliferationof ETFs change the existing price leadership held by the stock index futures

markets universallyor it is subject to a specific market? Again, according to Madhavan and Sobczyk (2016), there is no

simple answer existsto the question of whether ETFs or index futures present the more cost-efficient alternative. This

is because either can be characterized by factors such as short- and long-term investmentsas well as fully-funded and

leveraged investments. However, Deville et al. (2014) asserted that ETFs attract long-term position hedgers and liq-

uidity traders, and hence, ETFs proliferationmay result in the redistribution of index traders across the index markets,

which, in turn, can enhance the price efficiency.

After the extensive investigationof the literature, we are urged to further study the role of ETFs in price discovery.

This issue is particularly significant and urgent as the recent proliferation of ETFs may lead to changes in the existing

price discovery structure. Toaccomplish the above-sated purpose, we undertake an extensive study of price discovery

for three major European price indices, focusing on whether ETFs have surpassed futures or spot indices to become

the leading information transmission vehicle. In particular, we examine three major European stock market indices

(FTSE 100 in UK, CAC 40 in France, and DAX 30 in Germany), their futures and ETFs, using a large-scale dataset