The collapse of ETF prices on Aug. 24 prompted ETF providers, market makers, stock exchanges and Securities and Exchange Commission officials to begin looking at how to prevent a repeat of that day. But there's no consensus yet on what needs to be done.
The price dislocation lasted for an hour at most, but it was long enough to reverberate through the exchange-traded product industry, raising questions about the stability of the funds in volatile markets.
Investors aren't spooked yet and the industry continues to grow, but repeat events could cause permanent damage to what's now a $2 trillion industry, said Todd Rosenbluth, director of ETF and mutual fund research at S&P Capital IQ.
“If investors continue to get hurt, they are going to stop using ETFs,“ he said.
Steve Luparello, director of the SEC's division of trading and markets, said the SEC is conducting a “careful examination” of the events of Aug. 24, according to a transcript of the agency's equity market structure committee, which met on Oct. 27.
ETFs have been one of the fastest-growing segments of the investment industry since the first ETF was introduced in 1993, fueled by low fees and the ability to trade baskets of securities on an exchange without waiting until the close of the day.
Confidence, though, was rattled on Aug. 24, the market's worst day in four years measured by percentage declines.
The S&P 500 fell by as much as 5.3% in the opening minutes of trading on Aug. 24 and the Dow Jones industrial average fell by a little more than 1,000 points at the open before rebounding. But ETF prices dropped much more dramatically, as much as 30% to 50%, within minutes of the market open and stayed down for as long as an hour even though the underlying stocks had not suffered such severe price drops.
For example, State Street Global Advisors' SPDR S&P 500 ETF Trust, the world's largest ETF by assets, traded as low as 48.94, while its index was at 71.96, said FactSet Research Systems Inc., a financial and market data provider. It began accurately tracking its index roughly an hour after the market opening.
BlackRock Inc.'s iShares Core S&P 500 ETF traded as low as 51.27, while its index was at 73.46, FactSet said. It began accurately tracking its index also a little more than an hour after the open.
Mark Flannery, director of the SEC's division of economic and risk analysis, said at the Oct. 27 meeting that the SEC is looking at instances of ETFs trading substantially away from their perceived net asset value, according to the transcript.
Following the flash crash of 2010, the SEC approved a series of circuit breakers that would shut down the trading of individual securities or even the entire stock market when prices dropped or increased rapidly. For individual ETFs and stocks, U.S. exchanges are required to issue a trading halt when a security leaves a pricing band and moves up or down by more than 10% at the market's opening or closing, and more than 5% in between those periods.
The pricing band is determined on a rolling five-minute basis. Once leaving the price band, securities have 15 seconds to fall back into the band before a minimum five-minute trading halt is called.
Some ETF market participants question whether those trading halts on Aug. 24 exacerbated the problem.
Traders said they couldn't properly price ETFs on that day because of trading halts on individual stocks, forcing them to widen ETF bid-ask prices because of a lack of pricing information on the stocks in an ETF basket.
“You had this environment where securities were not trading freely and so ETFs were acting independent of its basket's fair value,” said Reggie Browne, senior managing director-ETF trading at Cantor Fitzgerald in New York, in an interview.
Mr. Browne, who also serves on the SEC's equity market structure committee, said compounding the problem was that ETF share prices couldn't initially be recovered because ETFs experienced multiple trading halts, preventing price discovery from occurring.