Why This ‘Open Letter’ To SEC Matters

ETF industry petitions the SEC for market microstructure changes.

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Reviewed by: Dave Nadig
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Edited by: Dave Nadig

This morning a rather unprecedented thing happened. The ETF industry, as best as you can define it, got together and agreed on something important: that the SEC needs to seriously overhaul some of the market microstructure to fend off future trading problems in ETFs (and, for that matter, stocks).

(You can read the full text of the letter here.)

There are a few reasons why I think this is important, but first, why do I call it “unprecedented”?

Why It Matters

In the beginning, back in 1993, there was the SPDR S&P 500 (SPY | A-97): a simple product, built off the ideas of similar products in both Hong Kong and Canada, which let investors trade the S&P with a single trade. It was a revolutionary idea.

And a lot of people hated it.

It was enormously disruptive. It lowered the cost of entry for institutions and individuals alike. In the intervening 23 years, ETFs have grown like wildflowers after a firestorm. With more than 1,800 ETFs currently trading in the U.S., virtually every investable asset class in the world is now available for a bargain basement price, with a single trade.

And as the industry has grown, it’s inevitably fractured a bit. It was only five years ago that there was a congressional hearing on whether ETFs were a good thing or a bad thing. Those hearings created real dissention among ETF providers, traders and even analysts: about what it even meant to be an ETF; about the role of more trader-oriented products; and about marketing and even regulating what could be called an “ETF.”

So for 18 industry participants to come together and speak as one voice is, in fact, pretty unprecedented.

What’s The Plan?

And what’s that voice saying?

In a nutshell: Let’s fix the broken parts of the market.

Aug. 24, 2015, was a bad day. I’ve written about it here extensively. It was a bad day largely because of inconsistencies between how different exchanges handled big swings in securities (the limit up/limit down—LULD—circuit breakers) and how securities were reopened after those breakers were hit.

Those inconsistencies are simply a reflection of the fact that the U.S. market is incredibly fragmented, and regulations have allowed that fragmentation to create big differences between trading venues.

At the core, the letter suggests just a handful of things:

  • Harmonize how LULD is handled across all exchanges
  • Collapse the reopening of a security to the listing exchange after a halt
  • Publish all order imbalances during reopening auctions
  • Define any trade outside of the LULD bands as clearly erroneous

These are actually quite modest proposals—not “modest proposals” in the Jonathan Swift sense—but actually simple, implementable solutions that require a small bit of SEC action. They’re not even very novel.

I wrote about them back in October, not because I’m smart, but because basically every coffee-shop conversation I had with anyone in the industry after Aug. 24 kept coming back to these basic ideas. Call it an “ETF trading zeitgeist.”

Alas, Deaf Ears Already?

As cool as it is that the industry has managed to coalesce around these ideas, the sad thing is that the SEC does not seem likely to respond. Just Tuesday—two days before this letter was released—the Wall Street Journal covered comments by Chairman Mary Jo White with the headline “SEC’s White Says Stock-Market Overhaul Won’t Happen This Year.”

The point of that article was more about high-frequency trading and “Flash-Boy”-esque mishaps, which isn’t really what we’re talking about here. So, I’m hopeful that this letter at least gets printed out and put on the desks of Commissioners White, Stein and Piwowar.

It’s really just a few simple ideas that, implemented simply and cleanly, could go a long way toward improving investor outcomes during times of market stress.


Dave Nadig is the director of Exchange Traded Funds at FactSet Research Systems. You can reach him at [email protected] or on twitter @DaveNadig.

Prior to becoming chief investment officer and director of research at ETF Trends, Dave Nadig was managing director of etf.com. Previously, he was director of ETFs at FactSet Research Systems. Before that, as managing director at BGI, Nadig helped design some of the first ETFs. As co-founder of Cerulli Associates, he conducted some of the earliest research on fee-only financial advisors and the rise of indexing.