ETFs, Alpha-Bits, and Two Articles About the August 24th Meltdown
As a child growing up in the 1970s, Alpha-bits was one of my favorite breakfast cereals. What other cereal gave you a Jackson Five record built into the cereal box? It was so popular that the Post cereal company kept trying to introduce new derivative versions of the original beloved “breakfast candy”: Marshmallow Alpha-Bits, Crazy Shapes Alpha-Bits, Frosted Alpha-Bits, Brown Sugar Alpha-Bits, and so on. Frankly, none of the derivative Alpha-Bits caught on really, and it was just too complicated being at the grocery store trying to pick between them.
Today when I think about the stock market, I kind-of think of simple index ETFs as being the original Alpha-Bits, and all the ensuing ETPs (Doubles, Triples, Inverse, notes, VIX ETFs, Actively Managed ETFs) as the derivatives. And I think perhaps they have become too complicated. I think the SEC thinks they have become too complicated as well; after all why else would they request comment on all things ETF, as they have just this past June?
The SEC realizes how important ETFs have become in our modern markets. They realize how much they have grown, and how widely they are held and traded. And they realize that the public thinks that they always trade close to the value of their contents individually (which is not a good assumption). The SEC also thinks they always should trade close to the value of their underlyings, and have implied so when they rejected Blackrock’s proposal to float an ETF that was actively managed, whose contents would be kept secret, which couldn’t trade super- fast with updated prices measured in fractions of a second.
They sure did receive many ETF comment letters from the public. Less than two weeks ago, we even sent you a note highlighting comment letters from Jane Street and Flow Traders (two large “HFT firms” and Authorized Participants in the ETF market).
Today we want to highlight two articles that pertain to ETFs and the August 24th market stress meltdown. First, Bob Pisani highlighted a JP Morgan note by Marko Kolanovic (bet your received it direct from JPM) that explained what brought about the “ETF Flash Crash” on August 24th. Marko talked about the perfect storm that happened that morning, and noted that a part of the blame goes to the fact that high speed traders have models that shut down that morning, because
- NYSE Rule 48 complicated things.
- Many market participants withheld liquidity when they weren’t sure what the prices were, or weren’t sure if they were correct.
- Only half the S&P500 stocks were open by 9:35, yet the ETFs were allowed to trade anyway.
Marko is widely followed, and widely respected and revered as one who knows what he is talking about. Be sure to read his piece thoroughly, even if some HFT market makers disagree with him:
The second article we want to highlight relates to the happenings on August 24th as well. Modern Markets Initiative (HFT lobbying group primarily representing Quantlab, GTS, Hudson River Trading, and Tower Trading) has written a letter to the SEC with three suggestions for fixing the ETF market, and Bloomberg has an article highlighting their letter. Give it a read! The article points out that these HFT firms worry that they can’t be relied upon to “provide liquidity” on tumultuous days like August 24th. The lobbying group suggests “three fixes” that would help them out, and allow them to continue their prop trading liquidity provision in times of stress:
- Stock exchanges should clearly state that they will not break ETF trades solely because of wide spreads from NAV.
- Eliminate the short sale Reg SHO price restriction for high speed firms like Authorized Participants.
- Allow that mom and pop retail ETF trades be exempted from getting filled when an ETF’s price is more than 5% away from NAV.
How can we prevent August 24th-like price dislocations from happening again? Should there be tighter circuit breakers implemented for ETFs? Should high speed traders, and they alone, get exemptions from short sale rules? Should trades never ever be broken, no matter what? There is no easy answer. Not only have markets become complex, but so have financial derivatives – including ETFs. Rules and Regs have not kept up.
And unfortunately, there are too many different brands of Alpha-Bits allowed and approved by the SEC to trade in the market place.
One final note: in January 2010, before the May 6th Flash Crash, the SEC requested comment from the industry on Equity Market Structure. In June 2015, before the August 24th ETF melt-down, the SEC requested comment from the industry on all things ETF. Perhaps the next time the SEC requests public comment on something very big in our industry, we should immediately fasten our seatbelts. The SEC’s ability to predict black swans is starting to look pretty impressive.