LULD Rules – Why The ETF Industry’s “Open Letter” To The SEC Matters by Dave Nadig, Factset
This morning, a rather unprecedented thing happened. The ETF industry, as best as you can define it, got together and agreed on something important: that the SEC needs to seriously overhaul some of the market microstructure to fend off future trading problems in ETFs (and, for that matter, stocks).
(You can read the full below.)
There are a few reasons why I think this is important, but first, why do I call it unprecedented?
Why It Matters
In the beginning, back in 1993, there was the SPDR S&P 500: a simple product, built off the ideas of similar products in both Hong Kong and Canada, which let investors trade the S&P with a single trade. It was a revolutionary idea.
And a lot of people hated it.
It was enormously disruptive. It lowered the cost of entry for institutions and individuals alike. In the intervening 23 years, ETFs have grown like wildflowers after a firestorm. With over 1,500 ETFs now trading in the U.S., virtually every investible asset class in the world is now available for a bargain basement price, with a single trade.
And as the industry has grown, it’s inevitably fractured a bit. It was only five years ago that there was a congressional hearing on whether ETFs were a good thing or a bad thing, and those hearings created real dissention among ETF providers, traders, and even analysts — dissention about what it even meant to be an ETF and about the role of more trader-oriented products, dissention about marketing and even regulating what could be called an “ETF.”
So for 18 industry participants to come together and speak as one voice is, in fact, pretty unprecedented.
What’s The Plan?
And what’s that voice saying?
In a nutshell: let’s fix the broken parts of the market.
August 24, 2015 was a bad day. I’ve written about it here extensively. It was a bad day largely because of inconsistencies between how different exchanges handled big swings in securities (the Limit Up/Limit Down circuit breakers) and how securities were re-opened after those breakers were hit. Those inconsistencies are simply a reflection of the fact that the U.S. market is incredibly fragmented, and regulations have allowed that fragmentation to create big differences between trading venues.
At the core, the letter suggests just a handful of things:
- Harmonize how LULD is handled across all exchanges
- Collapse the re-opening of a security to the listing exchange after a halt
- Publish all order-imbalances during re-opening auctions
- Define any trade outside of the LULD bands as clearly erroneous
These are actually quite modest proposals — not “modest proposals” in the Jonathan Swift sense — but actually simple, implementable solutions that require a small bit of SEC action. They’re not even very novel. I wrote about them back in October, not because I’m smart, but because basically every coffee-shop conversation I had with anyone in the industry after August 24 kept coming back to these basic ideas. Call it an “ETF Trading Zeitgeist.”
Alas, Deaf Ears Already?
As cool as it is that the industry has managed to coalesce around these ideas, the sad thing is, the SEC does not seem likely to respond. Just Tuesday – two days before this letter was released – the Wall Street Journal covered comments by Chairman White with the headline “SEC’s White Says Stock-Market Overhaul Won’t Happen This Year.”
The point of that article was more about High Frequency Trading and Flash-Boysesque mishaps, which isn’t really what we’re talking about here, so I’m hopeful that this letter at least gets printed out and put on the desks of Commissioners White, Stein, and Piwowar. It’s really just a few simple ideas that, implemented simply and cleanly, could go a long way towards improving investor outcomes during times of market stress.
Talk to Dave Nadig in our daily ETF briefing. Call 1-800-721-6994, ID: 1383726 at Noon Eastern each trading day.
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LULD Rules – ETF Industry’s “Open Letter” To The SEC
The Honorable Mary Jo White
Securities and Exchange Commission
100 F. Street, NE
Washington D.C. 20549
Re: SEC Action to Address Market Structure Issues Related to August 24, 2015
Dear Chair White:
We are writing with respect to the Commission’s continued efforts to analyze ways to improve equity markets structure rules in response to the events of August 24, 2015. The undersigned represent a broad spectrum of market participants; including asset managers, ETF providers, industry analysts, institutional and retail broker-dealers, and professional market makers and liquidity providers. The undersigned are all actively involved in today’s equity markets, but have different business models and perspectives. Despite these differences, the undersigned collectively agree on certain improvements which must be made to our equity markets in response to the events of August 24th. We believe the SEC should prioritize the efforts outlined below and that these improvements can be implemented swiftly.
Preliminarily, we commend the Commission for its continued focus on the trading events of August 24, 2015. The recent research note, Equity Market Volatility on August 24, 2015, from the Division of Trading and Markets, Office of Analytics and Research provides meaningful data on the trading impacts of the operations of our equity markets on that day. Many market participants, including the SEC, exchanges, broker-dealers and buy-side institutional investors have spent considerable time over the past six months analyzing data, reviewing existing limit-up/limit-down rules (LULD), and gaining an understanding of other rules and practices of the various exchanges which impacted the events of August 24th.
At this time, we believe most market participants have reached a consensus on certain opportunities to improve existing market structure rules to limit the likelihood of a similar event occurring in the future. Absent these changes, especially with the volatility in the current equity markets, we are concerned that the markets are susceptible to a similar event occurring at any time. Most importantly, we believe the only way to address these issues is through SEC action.
Fundamentally, it is important to note that we support the LULD structure across the equity markets and the fundamental principles behind such a structure. We support the LULD goals of preventing erroneous executions from occurring in the first place and pausing trading in individual securities in times of dislocation so that the markets have sufficient time to react to news and establish appropriate prices for individual securities. In fact, we believe the existing LULD rules mitigated the impact of the events of August 24th. That said, August 24th provides an opportunity to improve existing rules and ensure the markets continue to facilitate the goals of LULD in times of stress.
There are a variety of factors which contributed to the events of August 24th, including delayed openings, the influence of market and stop orders on the markets, and the interaction of market wide circuit breakers in times of extreme volatility. Nevertheless, we believe the following contributed to the events of August 24th and are issues which can be addressed immediately: 1) a lack of consistent LULD reopening procedures across exchanges, particularly with respect to price collars of certain exchanges which are not consistent with the principles of LULD; and 2) clearly erroneous rules and procedures of exchanges which are not consistent with LULD. We believe the SEC is in a position to swiftly address these improvements to the existing LULD structure.
LULD Reopening Procedures – We believe the SEC should direct the exchanges to harmonize their rules regarding the reopening of a security that has entered a LULD halt in an effort to reduce complexity and establish more liquidity-based reopenings. August 24th demonstrated an inconsistency in the standards for reopening securities that have halted under existing LULD rules. When the SEC approved LULD, it explicitly decided that the rules would not apply LULD price bands on the reopening of securities that had entered a LULD halt because the need for a trading pause recognized that a security could reopen at a price that is “significantly above or below its previous price [and that the lack of price bands on the reopen] is reasonably designed to allow for more fundamental price moves to occur.” NYSE Arca’s procedures, for example, imposed restrictive collars on the prices at which securities could reopen for trading (1% from the last trade prior to the halt for certain securities) and limited market participants’ ability to provide liquidity at reasonable prices. On August 24th, this practice caused securities to reopen at prices that were not indicative of market conditions at the time and resulted in certain securities experiencing multiple LULD halts after short periods of sporadic trading. The restrictive price collars of certain exchange’s reopening procedures are, in effect, inconsistent with the conclusions of the SEC in approving LULD. Establishing consistent standards for pausing trading across the markets is a fundamental purpose of LULD, and therefore, consistent standards for resuming trading are equally important.
We believe the SEC should promptly direct the exchanges to harmonize their LULD reopening procedures, subject to public comment and approval of the SEC, as follows:
- Securities should only reopen after taking appropriate steps to minimize or offset order imbalances;
- Price collars on openings and reopenings should not impede price discovery. We believe price collars should mirror existing LULD price bands (5% and 10% for Tier 1 and 2 securities). If imbalances cannot be offset within such price collars, auctions should be extended in predefined and uniform time increments and price collars should be expanded based on predefined thresholds until such time as order imbalances have been appropriately minimized or offset;
- Trading should not occur at any exchange or market center until such time as the primary exchange has reopened the security and LULD bands have been disseminated and applied;
- Exchanges should be required to consolidate liquidity at the primary listing exchange during a LULD re-opening; and
- Order imbalance information should be disseminated across the markets during reopening auctions.
Clearly Erroneous Rules – LULD should, in practice, eliminate the need for separate clearly erroneous criteria. If LULD is working as designed, especially with harmonized and consistent reopening standards, trades that occur within LULD bands are, by definition, valid trades. Uncertainty as to the application of clearly erroneous rules hinders market participation in times of dislocation. We believe aligning clearly erroneous rules with LULD parameters will likely result in increased confidence on the part of market participants in providing liquidity in times of market stress.
Specifically, we believe the SEC should also harmonize clearly erroneous rules with LULD as follows:
- Clearly erroneous trades are trades which occur outside LULD price bands and associated consistent reopening standards;
- Exchanges have the onus of proactively enforcing LULD bands and promptly cancelling trades that fall outside such bands; and
- To facilitate this consistency, LULD bands should not be doubled during the beginning and ending of the trading day.
We believe the SEC should promptly direct the exchanges to propose harmonized improvements to their existing rules consistent with the above referenced principles. Absent SEC direction, the exchanges will not collectively accomplish the above referenced improvements. We believe these requirements are needed to make the LULD structure of our equity markets work as designed. We believe most market participants support the above referenced proposals.
Going forward, as a second step towards addressing market structure improvements informed by the events of August 24th, we believe the SEC should consider improvements to the opening of securities across the markets and the standards for triggering market wide circuit breakers. Market participants may have varying views on these topics and we understand further analysis is warranted to come to an industry consensus. For this reason, we believe the improvements to the LULD structure discussed above reflect a consensus among most market participants and could be implemented relatively swiftly, but only through SEC action. While these issues should be prioritized, other issues will continue to be evaluated by market participants and regulators as improvements progress.
We appreciate the continued focus of the Commission on these important issues, and each of the undersigned is available to assist in these efforts.
Martin Small, Head of US iShares, BlackRock
Reginald M. Browne, ETF Group, Cantor Fitzgerald & Co
Eric M. Pollackov, Managing Director, Charles Schwab & Co., Inc.
Dave Nadig, Director of ETFs, FactSet Research Systems
David A. Lewis, SVP/Head of Americas Trading, Franklin Templeton Investments
John Comerford, Managing Director, Instinet Holdings Incorporated
Jamie Selway, Global Head of Electronic Brokerage, ITG
Daniel Ciment, Global Head of Electronic Client Solutions, J.P. Morgan Corporate & Investment Bank
Robert Deutsch, Global Head of ETFs, J.P. Morgan Asset Management
Ian Schaad, Managing Director, Jane Street
Greg Tusar, Co-Head of Client Market Making and Trading Services, KCG
James Ross, Global Head of SPDR ETFs, State Street Global Advisors
Damon Walvoord, Co-Head, ETF Group, Susquehanna International Group, LLP
Mortimer J. Buckley, Chief Investment Officer, The Vanguard Group, Inc.
Adam Phillips, Chief Operating Officer ETFs, VanEck
Douglas Cifu, Chief Executive Officer, Virtu Financial Inc.
Andrew Upward, Head of Market Structure, Weeden & Co.
David C. Cushing, Senior Vice President, Director of Trading and Market Strategies, Wellington Management Company, LLP
cc: The Honorable Kara M. Stein, Commissioner, SEC
The Honorable Michael S. Piwowar, Commissioner, SEC
Stephen Luparello, Director, Division of Trading and Markets, SEC