Exchange Glitch Made Market Orders Worse

Last week’s minor information hiccup had huge implications.

Careful ETF traders may have noticed what can best be described as “weirdness” in ETF trading last week on March 31.

First, during the early morning, the New York Stock Exchange had a “glitch” that caused some 160 ETFs to be untradeable for much of the hour between 10 and 11 a.m. It wasn’t just ETFs that were hit, but it was anything with a ticker from UTG to ZSML alphabetically.

Anything ring a bell there? How about all the Vanguard ETFs that start with V, or all those SSgA tickers with start with X?

For reasons that still haven’t been explained, because of these accidental trading halts, the Market-on-Close system for these securities—a whole five hours or so later—was also borked.

The end result? Quite a few ETFs, like the Vanguard Mid-Cap ETF (VO | A-99), traded wildly off of fair value—right at the close.

Source: FactSet Research Systems

How is this even possible?

The Market-on-Close Process

Most people mistakenly think the closing price is just whatever the last trade happened to be before someone rings a bell. In the modern markets, that bell is largely symbolic, and there’s far too much activity at the end of the day to leave to chance; so instead, most modern markets run what’s called a “closing auction.”

The way it works is pretty simple, but also pretty cool. Every day, some number of investors want to make sure they get the closing price for their buy or their sell. The reasons can vary, but almost always have to do with benchmarking. After all, every index is priced at the closing price, so if you’re an institutional investor who gets measured against an index, or worse yet, an actual index fund manager, it would seem like the “safe” bet is to just tell “buy the close.”

Throughout the day, NYSE collects orders flagged as either Market or Limit-on-Close. Starting at 3 p.m., NYSE starts sending out information about how imbalanced the close is going to be—are there a lot more buyers than sellers, or vice versa?

They continue to collect orders and disseminate this imbalance information right up until the close; however, after 3:45 p.m., once you’ve got your MOC order in, you can’t cancel it. Market makers can enter orders to offset the imbalance, whatever it might be at 4 p.m., but that’s it.

Once 4 p.m. hits, all orders are done, and the NYSE runs an electronic Dutch auction—a system that ensures the maximum number of shares can settle at a closing price.

The Information Problem

While the Dutch auction process is pretty simple and used in all sorts of markets, the most critical part of the whole end-of-day process is the dissemination of information. The goal of the entire process is for the closing price to be as logically derived from all the trading leading up to 4 p.m. as possible, minimizing volatility and maximizing crossing.

As the close approaches, all the disseminations of imbalances NYSE does are designed to prompt market makers and traders into recognizing where things are headed. If you know, for instance, that there’s a huge amount of stock being sold at the close, well, you might want to sell now, and then put in an order to rebuy on the close—selling high, buying low. The whole process should settle down trading and make for an orderly, predictable close.

But when there’s a hiccup in that information flow, that process breaks down. And that’s apparently what happened here.

Traders used to seeing indications of the closing imbalance every five seconds right up to the close were in the dark, with no real indication of whether there were more buyers than sellers. My guess is that that spooked all of the market makers who might otherwise have placed closing-offset orders designed to automatically take the other side of the imbalance and lock in a small gain on the spread difference.

So all that was left were the poor schlubs who had sleepy MoC orders.

The Accidental Paint

The irony here is that this was also the final trading day of the first quarter. Whenever I see anomalous pricing in ETFs on the closing trade of a quarter or year, I’m inclined to call shenanigans—some unscrupulous fund manager trying to make themselves look good by artificially juicing a final print, which then gets used to calculate his performance, and thus the size of his Hamptons’ rental this summer.

And indeed, there will be a raft of managers who look like geniuses for “beating their indexes.”

Such gains, of course, are millisecond-short lived. VO, and every other ETF affected by this glitch, opened up right on fair value, just like they generally do every day, and all those gains were gone like tears in rain.

The moral of the story is as it always is: Don’t use market orders, and don’t trade the close.

Dave Nadig is VP and director of exchange-traded funds at FactSet Research Systems. At the time this article was written, the author held no positions in the security mentioned. You can reach Dave Nadig at [email protected], or on Twitter @DaveNadig.