Investment managers facing tough questions from regulators over what caused trading disruptions for hundreds of exchange-traded funds this week said they got hit by a double whammy.
First, volatility hammered futures markets Monday, hurting liquidity by making it difficult for market makers to obtain information that’s vital to valuing ETFs, according to firms such as State Street Corp. and Vanguard Group Inc., which are some of the largest providers in the $2 trillion industry. Then, once buying and selling began later in the morning, prices moved so sharply, they triggered trading halts for more than 500 ETFs.
“People are trying to understand what happened and understand the dynamics more broadly across the market,” said Tim Coyne, head of institutional sales and global capital markets for State Street Global Advisors’ ETF business. “We are having very similar conversations with regulators as with clients.”
Assets in ETFs, one of the fastest growing businesses in the money-management industry, have increased almost sevenfold over the past decade, largely because investors view them as easier to trade and cheaper than traditional mutual funds.
Monday’s tumult, initially sparked by concerns over an economic slowdown in China, showed a downside, as ETFs can be vulnerable to price swings during periods of market stress, partly because some are less liquid than stocks.
U.S. Securities and Exchange Commission officials are now reviewing whether they should revise certain safeguards put in place after the May 2010 flash crash, due to concerns that those protections contributed to problems this week for ETFs, said a person familiar with the agency’s discussions, who asked not to be named because the examination is in its early stages.
The Treasury Department is also looking into the market volatility, with officials including counselor Antonio Weiss speaking with regulators, executives at ETFs and exchange operators, according to two people familiar with the conversations.
Trading in BlackRock Inc.’s iShares ETFs was paused more than 200 times, while those sponsored by State Street and Vanguard were halted more than 70 times, according to data from Nasdaq OMX Group Inc.
Some ETF providers said transactions were interrupted because many stocks didn’t trade until well after the market’s scheduled 9:30 a.m. opening. The top five holdings in State Street’s ETF tracking the Standard & Poor’s 500 Index opened between 9:31 a.m. and 9:37 a.m., according to Coyne.
“As market makers were looking to price this, the information they use is on the underlying securities that comprise that ETF,” he said. “On Monday, that price discovery process was delayed, because many stocks on the exchange had delayed openings.”
Under SEC rules that became effective starting in 2013 and are intended to curb volatility, trading in stocks and ETFs is paused when prices exceed a preset range. On Monday, some ETFs whose values collapsed were stopped for a second time as their prices rose, said Joel Dickson, global head of investment research and development at Vanguard.
Even before this week, the SEC had asked exchanges to explain why trade halts are more common for ETFs than individual stocks, according to the person familiar with the matter. The agency continues to talk to market participants and monitor further trading, said SEC spokeswoman Gina Talamona.
“There needs to be an examination of limit up-limit down, in the context of whether it worked as it was intended to,” Vanguard’s Dickson said.
The New York Stock Exchange, whose Arca venue hosts trading for many ETFs, is studying how to enhance its rules and systems in order to ensure that trading remains orderly “during extreme market-wide events,” said Steve Crutchfield, NYSE’s head of ETFs, options and bonds.
The SEC’s inquiry will build on an effort the agency launched in June, which sought answers to more than 50 questions in a request for public comment about how ETFs and similar products trade.
Separately, SEC officials are looking at whether trading on Monday was affected by delays in disseminating market data to brokers, the person said.
The New York Stock Exchange and Nasdaq operate price feeds that broadcast the current best offer to buy or sell a stock. The SEC is looking at whether the feeds disseminated prices more slowly than under normal trading conditions, according to two people familiar with the matter.
Monday’s trade halts and situations in which some ETFs declined much more than the underlying stocks that they’re linked to weren’t the only black eyes for the industry this week.
Technology provided by SunGard Data Systems Inc. prevented Bank of New York Mellon Corp., a custody bank, from providing closing prices for more than 10 percent of ETFs and some mutual funds.
The breakdown prevented the bank from issuing net asset values, the equivalent of a closing price, on Monday after markets plunged. Guggenheim Partners, a money manager, was one of the firms whose ETFs were affected, with some of its funds posting blank net asset values. SunGard said in a statement the incident wasn’t related to market turmoil and was caused by an operating system change.
While many investors were able to buy or sell ETFs during the recent volatility, some retail investors were harmed because they used orders that automatically execute at the prevailing market price. Vanguard said it cautions retail investors to avoid so-called market orders especially at the beginning of the trading day, when prices can be more erratic.
“You could say the onus is on the person putting that market order in, but most people don’t even know any of the terms,” said Eric Balchunas, senior ETF analyst at Bloomberg Intelligence. “There may need to be some regulation to protect those people because they are in the market.”
© Copyright 2021 Bloomberg News. All rights reserved.