They were perplexed. After the flash crash on May 6, 2010, the Securities and Exchange Commission thought it put in place the proper mechanisms to minimize such market events. And for five years, it seemed they had. Then August 24, 2015 happened, and ETFs found themselves in the eye of this storm. But were they to blame?
“8/24 was really the sum result of the U.S. market equity structure and not a result of ETFs in general,” says Dave LaValle, U.S. Head of ETF Capital Markets at State Street Global Advisors. “With the U.S. futures limit down 5 percent pre-open, and stocks indicating down 6-7 percent after a strong sell-off in Asia that led to a European sell-off, market makers were experiencing uncertainty that gave them pause in terms of entering the marketplace with confidence.”
Not until 9:57 when all S&P 500 equities finally opened were market makers able to price ETFs, which had been open since 9:30. However, those twenty-seven minutes in between created extreme uncertainty that caused widening spreads and massive dislocations—but only for U.S. domiciled ETFs with U.S. equity underlying securities. Fixed-income ETFs tracking either U.S. bonds or international bonds, international equity ETFs and non-U.S. domiciled ETFs tracking U.S. equity indices did not participate in this flash crash. And not all U.S. equity ETFs were impacted in the same way.
What was it about the U.S. equity market structure that lent itself to this massive dislocation and why did some ETFs experience higher dislocations?
“In simple terms,” LaValle says, “the exchanges, liquidity providers, liquidity takers [ETF buyers] and ETF issuers each had a role.” Called together by the regulating agencies afterwards, these parties gathered to determine what went wrong and subsequently implemented various mechanisms to reduce the likelihood of a similar crash.
Different This Time?
The SEC and the exchanges believed the chance of a flash crash was low after implementing the limit up/ limit down regime following May 2010. This new rule passed all the tests during its piloted phase and staggered market roll-out, holding up strong against individual stocks trading to zero, which was what occurred in the May crash. But during the morning of August 24, this rule had an unintended consequence.
“Collectively in a broad-based market move, the limit up/ limit down rules that were in place did not do an adequate job of stabilizing the market to allow liquidity to form efficiently, which is what happened on August 24,” explains LaValle. By triggering trading pauses, sometimes repeatedly, willing buyers could not effectively come into the market to offset the sellers.
“Through the addition of amendment 10 [which changed the methodology for determining the reference price] and amendment 12 [which modified the reopening process after a stock is halted] to the limit up/ limit down plan, the markets have become more resilient by improving reference pricing and smoothing out calls for liquidity after a security is halted,” LaValle says.
Together with the elimination of stop orders, the cascading effect which overwhelmed the markets on August 24, these amendments held up well when tested during recent market events such as the mornings after Brexit and Donald Trump’s election win.