ETF Industry Needs Major Reform: SEC’s Aguilar

ETF Industry Needs Major Reform: SEC’s Aguilar

It looks like the ETF industry is under the gun. Securities and Exchange Commission officials held a meeting of the Investor Advisory Committee in Washington, D.C. on Thursday, and began to lay out the case for reform in the ETF industry. In specific, SEC Commissioner Luis Aguilar outlined the kind of questions they’re asking in their inquiry regarding the rapidly-growing exchange-traded funds market.

Questions about the ETF industry began to emerge after August 24th, an extremely volatile trading day and he worst session for U.S. stocks in four years. August 24th witnessed multiple halts in both stocks and ETFs, stoppages that short-circuited the arbitrage mechanism of ETFs and led to ETF prices plunging well below the indexes they’re designed to track for a short period of time. The major glitch in the system was a painful lesson for investors and has brought regulators attention to a number of problems with overlapping market rules implemented following the 2010 “flash crash”.

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Statement from SEC Commissioner Aguilar about ETFs

Commissioner Aguilar did not beat around the bush in his speech at the SEC committee meeting. He made his agenda clear in his introduction: “Why ETFs proved so fragile that morning raises many questions, and suggests that it may be time to reexamine the entire ETF ecosystem.”

In his remarks, Aguilar raised four general questions about the events of August 24th.

1) Should ETFs have industry-specific volatility curbs? Do so-called limit up/limit down volatility bands need to be updated? Should market-wide circuit breakers factor in the number of securities that are currently halted?

2) Should rules for “clearly erroneous” trades be reformed?

3) What roles should exchanges have in ETF trading?

4) How can market makers be more incentivized to stay in the market during times of extreme volatility?

Democratic SEC Commissioner Aguilar also went on to argue that the commission needed to ask bigger, even existential questions about the ETF industry and its very rapid growth, including the issue of whether the growth needed to be curtailed. Here, he outlined four general areas for consideration:

  • How does the growth of ETFs and their gradual movement into less liquid asset classes challenge the effectiveness of the ETF arbitrage and pricing mechanisms?
  • Are sophisticated traders able to exploit inefficiencies in the pricing mechanisms of less liquid ETFs and exploit retail investors?
  • Should alternative pricing methods for less-liquid ETFs, such as so-called NAV-based trading, where ETFs are traded at a specific premium or discount to the ETF’s net asset value, be allowed?
  • Should the growth of ETFs be limited to protect investors and the entire financial system?

ETF Flash Crash

Statement from SEC Chair Mary Jo White on ETF Industry

SEC Chair Mary Jo White noted in her remarks at the meeting on Thursday that the commission is paying “close attention” to pricing of exchange-traded products. She went on to add that the SEC is “continuing to evaluate trading data regarding August 24,” and still reviewing, among other things, “whether the behavior of ETPs can be explained by uncertainty in pricing of the underlying assets, the nature of liquidity demand and supply for ETPs, and/or the low trading volume in many individual ETPs.”

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