‘Flash Crash’ Shows It’s Wake-Up Time For Exchanges

May 14, 2010

Richard Keary, special to IndexUniverse.com, writes that the causes of the May 6 ‘flash crash’ are complex, but the lessons are simple: The exchanges urgently need to coordinate trading and recognize that the ETF is here to stay and must have its own rules to better protect investors.

It looks like a confluence of factors caused the May 6 “Flash Crash" in U.S. financial markets, but two problems loom largely in its aftermath: a lack of coordination among exchanges and an underappreciation of how ETFs work and how important they have become -- all of which unfairly victimized ETF investors, who faced about three-quarters of the canceled trades that day.

Indeed, the real victims in the flash crash are ETF investors and the real culprits are not, as some reports suggest, ETFs themselves. Rather, the blame should be placed squarely on the exchanges, outdated market regulation and the process of canceling trades that left ETF investors with losses that can’t be recouped.

Let’s start with the New York Stock Exchange’s decision to slow trading down when it began to witness order imbalances last Thursday. It had every right to do so under Reg NMS, a 2007 rule aimed at addressing the increasingly electronic nature of securities trading. But depriving the market of liquidity while most trading continued, unleashed price dislocations that disproportionately affected ETFs.

Price dislocation in one stock can affect the pricing in multiple ETFs, because ETFs are baskets of stocks. This basic fact of how ETFs work is underappreciated by the exchanges and regulators, and it clearly hurt ETF investors last Thursday. ETFs account for roughly 25 percent of the trading volumes on U.S. exchanges. One would hope that exchanges would pay more attention, but they evidently haven’t yet.

Outdated Rules

This leads us to outdated rules surrounding aberrant trades involving issues from technology glitches to inadvertent “fat-finger” trader errors. The rules, which allow an exchange to cancel any trade that is at least 10 percent away from the previous price of the security, are more suited to individual securities than to ETFs.

That’s because an ETF is priced based on the value of its underlying index, and a movement of just 3 percent from the value of its underlying index price would be an egregious trade. Again and, quite clearly, exchanges and regulators failed to consider that 25 percent of the market that are ETFs. The point is ETFs are traded and priced differently than common stocks. Thus, they need their own rules.

One problem that has kept trading and regulatory frameworks from being changed to reflect new circumstances is that exchanges are more concerned with their quarterly profits than protecting investors. In other words, ETFs have always been a “low-priority product line” regarding exchange policy.

But last Thursday’s flash crash puts the shortcomings of the current trading system on center stage, creating a unique opportunity for exchanges and regulators to take a closer look at the complexities of trading and investing with ETFs.

In adopting new rules and regulations that do justice to the importance and particularities of exchange-traded funds, ETF-industry heavyweights need to be invited into the policy-making process. That will give the likes of iShares, State Street, PowerShares and Vanguard just as loud a voice as large issuers such as IBM, Microsoft and Coca-Cola.

All relevant participants will then be present to help create new rules designed to keep high-speed electronic markets interconnected so that if a link is broken, the whole system can shut down; and also to amend erroneous-trade rules so that ETF investors aren’t left holding the bag.

Richard Keary is the founder of Global ETF Advisors LLC, a New York-based firm providing clients with advice on regulatory and technological issues in the exchange-traded fund industry.

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