This Monday, August 21st, was a crazy day for stock markets. The U.S. Dow Jones Industrial Average was down 1000 points five minutes after the open, but bounced back to less than 200 points down within two hours. These huge price swings resulted in dozens of heart attacks and strokes all across the country, and also resulted in a “flash crash” in the ETF (exchange-traded funds) market.
As Dave Nadig, Director of Exchange Traded Funds for FactSet, points out in his August 26th article, scores of ETFs traded far below fair value for an hour or so Monday morning, and investors, fund management, analysts and regulators are all trying to figure out exactly what happened.
ETF Flash Crash – aking a closer look at trading in the Guggenheim Equal Weight S&P 500 ETF on Monday
The first fact to note is that the NYSE decided to take the rare step of invoking “Rule 48.” Rule 48 enables specialists.market makers to not set opening prices until trading has actually begun, protecting the market makers but also taking away key information from the market (and, by the same token setting up the markets for a speculative frenzy in the first few minutes of trading).
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Nadig decided to analyze the trading of Guggenheim Equal Weight S&P 500 ETF (RSP) on Monday to gain some insights into what happened and why.
He notes that RSP is quite liquid, trading more than a million shares a day (but not so liquid that there’s no opportunity to arbitrage out price differences or make money on the spread). Nadig also highlights that the underlying securities are easy to trade, and its possible to hedge any RSP position with an S&P 500 derivative or ETF and be reasonably close.
Of note, RSP was hammered in the “flash crash”Monday before it recovered, at one point dropping under $50 when the “fair value” for the underlying stocks never dropped below $71.
Five key conclusions about Monday’s ETF flash crash
Nadig offers five conclusions regarding the cause and effect of the ETF flash crash on Monday:
- Market makers backed off. He says: “Market makers are in the business of avoiding risk. When irrational actors are at work (and let’s be clear, anyone selling RSP for half off isn’t being rational), the smartest thing to do, if you’re the actual human being watching RSP trade, is to simply step out for a cup of coffee. That means stubbing out your bid and ask to a point you think nobody will hit.”
- Much of the trading was HFT algorithmic trading. For starters, human beings almost never trade just one share of an equity, and one-share trades were very common Monday. Another consideration is that close to half the trades were defined as intermarket sweep orders (ISOs), the most common type of HFT trade (ie, values speed over price), and retail traders are not placing ISO orders. Finally, he argues that anyone selling RSP for $50 when it was demonstrably worth $70 is irrational. Nadig notes: “Since I believe human traders generally express their irrationality more subtly, I think this points to broken HFT models that were unloading positions without regard to price or fair value.”
- Sleeping-stops kill. Nadig also suggests that the “regular” (non-HFT) investor who were hurt in RSP during the flash crash, it was due to a stop-loss order they had “sitting on the books”. Say you had a stop to sell if RSP if it dropped below $70. That means that right after the open, your order turned into a market order, and was then executed in order at the price at that time (which just happened to be more than 20% less than the underlying value of the stocks).
- The market operations functioned as designed. Nadig also says that iti s unlikely that any of these disastrous flash crash trades will be canceled. The trades all happened in an orderly, logical manner according to the rules in place. Rule 48 worked, in that the market makers at the NYSE were seemingly able to step out of the way and let the market come in and fill up the book before they had to offer prices. Moreover, the trading halts did exactly what they were designed to do.
- The system has real problems. Nadig continues to argue that the current market structure is not well designed for a situation where information is processed in milliseconds, but there is still the possibility of five-minute or longer trading halts. Today’s markets require close to complete transparency, yet the regulations for handling volatility actually remove transparency. In concluding, Nadig offers some possible solutions: “This is a market where speed is often valued over price—and we have an entire set of regulations to ensure that’s OK—yet we cry “foul” when speed is actually more important than price. Lastly, if we’re concerned about protecting individual investors, we need better education and controls around the most dangerous tool in the ETF investor’s toolbox: the market order.”