Most of trades during Thursday's unprecedented sell-off that Nasdaq and the NYSE plan to cancel involve ETFs, and the mystery as to why hasn't yet been solved.
Around two-thirds of all the trades during Thursday's extraordinary “flash crash” that Nasdaq and the NYSE say they are likely to cancel involved exchange-traded funds (ETFs) or exchange-traded notes (ETNs), though the reasons for this aren’t yet clear, according to new analysis from IndexUniverse.com
While ETF traders have been saying stocks were poised for some sort of downside correction, particularly in view of riots in Greece in the wake of Standard & Poor’s downgrade of that country’s sovereign debt to junk status, Thursday’s swift and unprecedented price action—between 2:30 and 3:00 p.m. EDT—clearly involved computers as opposed to panicked humans. Indeed, the slivers of salient time were in minutes, even seconds, IndexUniverse.com has found.
One longtime ETF industry insider told IndexUniverse.com that the episode should teach financial professionals two important lessons: First, that the widespread use of ETFs in those critical moments was enough to overwhelm the system and second, that the time has come to rethink and redesign trading systems to handle ETFs, which he said are clearly here to stay.
“It wasn’t an ETF product problem, it was a system problem, a structural problem,” the source said, speaking on condition of anonymity. “These people have not spent enough time and money to develop a system that can handle what has become a $1 trillion ETF industry,” he said referring to exchanges.
Of the 281 securities Nasdaq said had unusual trades that it will cancel, 193, or 68.7 percent of them, were ETFs or ETNs. The New York Stock Exchange reported a similar percentage of questionable trades involving exchange-traded products. The Big Board said 111 of 173 securities affected by questionable trades, or 64.2 percent of them, were either ETFs or ETNs. IndexUniverse.com compiled a full downloadable spreadsheet of the canceled securities, broken out by exchange and with ETF/ETNs separated from common stocks, and it is available here.
Nasdaq hasn’t admitted to any technological breakdown, but it has decided to cancel all trades executed between 2:40 and 3:00 p.m. EDT that took place more than 60 percent away from the last consolidated print at 2:40 p.m. Its decision can’t be appealed.
The Nasdaq list included funds from Claymore, Direxion, Fidelity, First Trust, HOLDRS, iPath, iShares, PowerShares, ProShares, Rydex, Schwab, State Street Global Advisors, Van Eck, Vanguard and WisdomTree.
In the heat of the selling, the Dow Jones Industrials average fell by almost 1,000 points, or nearly 10 percent, before erasing around two-thirds of those losses by the time the market closed. The, world’s biggest ETF, the SPDR S&P 500 (NYSEArca: SPY), fell as much as 10 percent in afternoon trade, before recouping much of that to close almost 4 percent lower at $112.94.
SPY shed another 1.5 percent on Friday, settling at $111.26.
The ETF-industry insider said his preliminary research showed that trading volume in SPY, as well as other widely traded ETFs, expanded dramatically as Thursday's episode unfolded.
He said SPY’s trading volume was about 5 million shares in each 5-minute interval between 9:30 a.m. and 2 p.m. EDT. But it began spiking in the 2:30-2:35 p.m. period, when it doubled to 10 million shares. Thereafter, in the next three five-minute intervals ending at 2:50, 20 million, 30 million and 25 million SPY shares changed hands, respectively.
He said SPY and other heavily traded ETFs became more reliable price-discovery tools than their individual constituent stocks, which became thinly traded during those critical moments. But the system was not able to process all the ETF orders, and that’s when things broke down and computers started spitting out truly incredible prices, some lower than a penny.
“ETFs have become the de facto product for the market. “My position is that they worked perfectly,” the source said, stressing that changes to the system to account for the growing use of ETFs—perhaps halting trade sooner than current NYSE curbs stipulate—may be necessary to avoid a repeat of Thursday's disorderly action.
After the October 1987 crash, the NYSE imposed curbs under which trade is halted for an hour if the market falls 10 percent; two hours if it falls 20 percent and for the whole day if it falls 30 percent.
Traders were calling the move to reverse trades unprecedented, and were at a loss to explain exactly how exchanges would be able to unwind the trades that were executed during the period of feverish selling
“There are so many settlement issues and clearing issues, I don’t know how they’re going to do it. It’s unprecedented, really,” said Paul Weisbruch, vice president of ETF sales and trading at Street One Financial, a King of Prussia, Pa.-based firm that specializes in ETF trading.
Weisbruch said the broad moves by Nasdaq and the NYSE to cancel trades will unfairly punish investors who were patiently waiting for a chance to buy when the market turned cheaper.
“For someone to say: ‘Oh, we’re going to reverse that because it was a mistake,’ is taking money out of the pockets of people who were astute enough to have limit bids out there,” Weisbruch added. “If they take those trades away, it takes away the confidence of the investor.”
It’s worth noting that throughout the crisis, the indicative NAV system—the system that publishes estimates of the “fair value” of ETFs—appears to have functioned smoothly. Although indicative NAV values dipped, a survey of select ETFs by IndexUniverse showed none of the irrational trading behavior of the affected ETFs. A trader who had either a mechanical or human system in place to check iNAVs before trading ETFs would not have sold shares at the low levels.
Under The Hood
In trying to assess what actually happened, IndexUniverse.com looked at one of the many ETFs that traded, literally, below a penny—the Rydex S&P Equal Weight ETF (NYSEArca: RSP). Its chart around 2:50 p.m. EDT Thursday is typical:
It will take some time to know precisely what happened, but one thing is clear: This was not the result of a single large player making a single bet. The damage happened quickly. At 2:45:05, 100 share lots of RSP were trading around $39, down for the day, but not catastrophic. Over the next 31 seconds, that price deteriorated over a few dozen trades, finally printing the last “rational,” but still scary, price of $24.50, at 2:45:36.
The very next trade is for 15 cents. That’s $0.15/share.
Immediately, a hundred or so trades on NYSE Arca ran through for $0.10/share. By 2:45:37, Nasdaq machine-trading caught up, and hundreds of trades rolled through for 100 shares each at a fraction of a penny.
By 2:46 p.m., some level of rationality returned to the market, with trades printing from $10 to $40.
Friday morning, all those penny trades were canceled. However, the damage that was done was very real for some investors, somewhere. Hundreds of RSP trades from $10 to $30 remain valid, and the losers in those trades are the victims, clearly, of what will inevitably be referred to as a “glitch.”