Knight’s Troubles = ETF Trading Woes

August 02, 2012

The Knight fiasco should teach us at least one thing: Be careful trading less liquid ETFs.

Knight Capital Group’s recent hiccups in market making are causing significant issues for ETF traders, particularly in less liquid ETFs.

In the two days prior to Knight’s “algo” troubles, the average spread at 12 noon Eastern time for an ETF that normally trades less than 50,000 shares a day was 56 basis points. Since the Knight kerfuffle, the average spread has been nearly double that: 94 basis points.

But it gets worse. For those low-liquidity ETFs for which Knight is the lead market maker on the NYSE, spreads have ballooned from 0.49 percent on average to a whopping 1.53 percent.



This didn’t happen at all for ETFs that trade more than 50,000 shares per day. In those cases, spreads widened by just 1 basis point, from 0.12 percent to 0.13 percent, and even the impact on the funds Knight makes markets in was minimal.

What does this mean for investors? It means if ever there were a time to tread carefully into illiquid ETFs, now’s that time.

Knight is the largest player in this corner of the market, providing liquidity as the lead market maker (LMM) for some 150 low-volume ETFs. LMMs make a commitment to the New York Stock Exchange to maintain constant quoting on ETFs, and in many of these less liquid ETFs, the LMM will be the only market maker quoting on a regular basis.

A spot check of Level 2 screens throughout the past two days showed Knight sitting well off the already-wide bid/ask spreads on many of these ETFs, implying that its market-making desk has had other things to worry about then, well, actually making markets in these small ETFs. And as it stepped away—or decided to take on less risk—the spreads widened.

For the more liquid ETFs, the market stepped in and provided liquidity perfectly, thank you very much.

It’s worth noting that not every ETF even has an LMM—our analysis only covered some 900 ETFs with LMM designation on the NYSE for which we had viable data. It’s also worth noting that this is an entirely anecdotal snapshot. Spreads change literally by the tick, and “average spreads” are open to a lot of definitional arguments and interpretations, especially in illiquid securities.

But until this blows over, tread very carefully in small ETFs. There’s a bit of a gap in the market right now, and the spreads remain very wide for smaller ETFs.



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