The events in the US equity market on August 24, 2015 marked the first true opportunity to assess the efficacy of reforms implemented in response to the 2010 “Flash Crash”,1such as individual stock trading halts, policies to address erroneous transactions, and the market-wide circuit breaker. For most of the day, the market functioned and remained accessible to investors at record-setting trading levels and volatility. But, during the first hour of trading, a tumultuous US market open precipitated rapid, anomalous price moves in many stocks, exchange-traded products (ETPs), and closed-end funds (CEFs). This ViewPointexamines the events of that first hour.
August 24 reminds us that we live in a world of increasing volatility, as technology and many other dynamics impact capital markets from equities to fixed income. For example, it was only a year ago that we experienced the Treasury “Flash Rally” on October 15, 2014. With the recognition that moments of high volatility and discontinuous pricing may be a persistent aspect of today’s markets, we see a need for market participants, exchanges, and regulators to improve the US equity market’s ability to cope with extraordinary volatility.
In this ViewPoint, we discuss the lessons from August 24 and analyze the brief breakdown in the arbitrage mechanism for many US-listed ETPs that invest in US equities. We believe that the industry and regulatory response should first focus on facilitating the free flow of pricing and order information across the US equity market ecosystem. We share recommendations to refine trading mechanisms and “guard rails” to enhance the resiliency of the US equity market, which we believe will promote fair and orderly markets and benefit the functioning of both ETPs and individual stocks. As discussed throughout this ViewPoint, proposed improvements must balance attempts to improve market resiliency with the preservation of the existing and well-functioning processes through which equity securities are traded today.
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Recent Volatility in the US Equity Market
In late August 2015, the US equity market experienced a rapid spike in volatility as global market sentiment weighed bearishly on stocks. During that period, the VIX volatility index doubled2and equity trading volumes surged as investors reassessed global growth prospects and inflation expectations.
Market activity on August 24 was particularly extreme. Before the market opened, global equity markets were down 3% to 5% and the e-mini S&P 500 future was limit down 5% in pre-market trading before wider price curbs went into effect at 9:30am.3Due to these pre-opening factors, the morning began under selling pressure with substantial order imbalances at the open as investors reacting to global macro concerns flooded the marketplace with aggressive orders to sell (that is, orders to sell without any restrictions as to price or timeframe such as market and stop-loss sell orders). According to the New York Stock Exchange (NYSE), the volume of market orders on August 24 was four times the number of market orders observed on an average trading day. Extensive use of market and stop-loss orders overwhelmed the immediate supply of liquidity, leading to severe price gaps that triggered numerous LULD trading halts.
The confluence of these factors contributed to aberrant price swings and volatility across the US equity market. For example, the S&P 500 index was at a low, down 5.3%, within the first five minutes of trading, then rallied 4.7% off the lows before selling off again late in the session to close down 3.9%.9Bellwether stocks such as JPMorgan, Ford, and General Electric saw temporary price declines in excess of 20%.10As shown in Exhibits 1 and 2, individual stocks as well as ETPs and CEFs experienced significant dislocations after the opening followed by unusual volatility.
Transparency and Information Flow
Price transparency and information flow in the US equity market were curtailed from the start, forming one of the key contributors to the day’s events. Anticipating widespread volatility, NYSE invoked Rule 48 prior to the open. NYSE Rule 48 suspends the requirements to make indications regarding a stock’s opening price and to seek approval from exchange floor officials prior to opening a stock.11By suspending time-consuming manual procedures, this action should have permitted Designated Market Makers (DMMs) to open stocks more quickly and effectively. However, this rule had the unintended effect of limiting pre-open pricing information in securities, especially for any stocks experiencing delayed opens. Although DMMs actively worked to facilitate a prompt open for all securities, the opening auction was considerably delayed for an extensive number of stocks. At 9:40am, nearly half of NYSE-listed equities had yet to begin normal trading.12These delays, along with the absence of pre-open indications, impeded the normal flow of information which market makers and other participants rely upon to perform their customary activities with respect to the market open.
Without this information, and with many securities experiencing delayed openings, correlations snapped with prices for securities in the same industry or ETPs tracking identical benchmarks deviating significantly from one another. In financials, for example, JP Morgan experienced a sharp decline, while Morgan Stanley did not. The basis between futures and cash prices for the S&P 500 index also widened considerably –futures traded at a 1.66% discount to the corresponding equity basket.13These dislocations heightened uncertainty in the market because the validity of automated pricing models becomes challenged when there are meaningful disparities between the prices of normally correlated securities. Additionally, since many of the computerized processes which support market making rely on futures as a reference asset, the ability of market makers to efficiently allocate capital and price risk was inhibited. Market makers faced further uncertainty on the cancellation of potentially “erroneous trades”, adding to their reluctance to trade. As we explain in detail in the ETP section, the lack of price transparency impaired the ETP “arbitrage mechanism” because market makers were unable to rely upon price information for individual stocks to determine when arbitrage opportunities exist between the ETP and its underlying basket, and to hedge their positions. In the absence of the necessary data, many market makers ceased arbitraging US equity ETPs.
Limit Up-Limit Down Rules
Limit Up-Limit Down rules were originally conceived as a reform in response to the 2010 Flash Crash to serve as circuit breakers or mechanisms to mitigate extreme price volatility in individual stocks by halting trading for a period of time when a price threshold (known as a “price band”) is reached. LULD rules were designed to address single security situations (e.g., “fat finger” or news events) but were not necessarily expected to be invoked in broad market scenarios where hundreds of securities undergo LULD trading pauses at the same time. Unfortunately, this was the case on August 24, when nearly 1,300 LULD trading halts occurred due to the market swings.14These pauses effectively curbed sharp price moves on the way down; but as liquidity replenished and price anomalies were discovered, the same rules delayed the ensuing price recovery as the trading halts continued to be applicable when prices fell and when prices rose. Due to both the duration and sheer volume of halts, LULD rules may have inadvertently impeded market transparency, since price discovery is constrained when securities are halted. Further, market makers needed to reinstate their automated pricing systems manually to resume trading once the trading halts were lifted. These manual and time-consuming modifications added to the disruption as many firms were not staffed to handle the volume of trading halts that occurred on August 24.
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