Now that the Securities and Exchange Commission is investigating the role of ETFs—and specifically inversed/leveraged ETFs—in the market volatility that we saw in August, it seems clear to me that ETFs are once again serving as a scapegoat for imperfections in U.S. market structure.
Didn’t we go through this with the “flash crash?” I have a lot of respect for the SEC and the terrible conditions that they are working through—its funding is being cut, it is tasked with implementing major portions of the Dodd-Frank Bill and all while it has to oversee market regulations and market participants.
To get to the point, this investigation that the Wall Street Journal first reported on is nothing more than a waste of the commission’s time and valuable budget, because there is no correlation between the use of ETFs—leveraged, inverted or otherwise—and market volatility. Incidentally, the SEC didn’t return calls made by IndexUniverse to inquire about the investigation.
ETFs, just like stocks, are vehicles that investors—both high-frequency traders and long-term buy-and-hold types alike—use to access markets. If we’re going to investigate ETFs for market volatility, then shouldn’t we also investigate bank stocks, tech stocks and biotech stocks?
It seems to me that every time there’s turmoil in the U.S. markets, ETFs get the blame.
A History Of Blame
If we examine the history of market volatility; the specific market conditions in August; and our current market structure rules, it becomes clear as a bell there’s no correlation between ETFs and market volatility.
Grappling with volatility and its causes in markets has been around much longer than ETFs. That begs the question, is today’s market volatility different than yesterday’s, or have we just forgotten what it was like?
In the past 15 years, we have seen volatile markets with multiple 100-point moves in successive days due to the tech bubble, the 9/11 terrorist attacks, the housing market bubble, and the current debt crisis and its aftermath, to name just a few.
To take the premise of the SEC inquiry head-on, some of these periods of heightened volatility occurred before the first creation of leveraged and inverted ETFs in 2006. So who did we blame for market volatility prior to 2006?
- Nasdaq was once the favorite scapegoat for market volatility, as it led the transition toward the market-maker system that prevails today, and away from the specialists who once controlled order flow at the New York Stock Exchange.
- Program trading was another; no one on Main Street or in Washington could explain what it was; therefore, it must have been be causing volatility.
- Also, let’s not forget market fragmentation, in the form of numerous electronic trading networks, such as Instinet and Arca that have muddied the ways market participants can access liquidity, and have given institutions an advantage over retail investors.
The truth is, market volatility has always been a function of market conditions, and how the mechanics of market structure meet those conditions. Solutions to volatility-related problems were based on a combination of regulatory reform and new technologies adapted by the trading community and the various stock exchanges.
Currently the chicken coop is being run by high-frequency traders whose technology has yet to be properly regulated by the SEC and the exchanges.
This was an unintended consequence of Regulation NMS, which was implemented in 2007 and was designed to offer the lowest price in favor of the quickest execution or reliability to fulfill a given equities order. Regulators have clearly been slow to adopt a proper rule set to account for high-frequency traders for this new type of market participant.
The real question, the way I see it, is, will the SEC end up investigating their own process of regulating new technologies or will they focus attention on financial instruments like ETFs that are affected by the problem but are clearly not the cause of it?
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