ETF Capital Markets Desk: Flash Crashes and the Fed

    David Mann

    David MannHead of Capital Markets, Global Exchange-Traded Funds (ETFs), Franklin Templeton Investments

    So-called “flash crashes” refer to a market phenomenon where a dramatic drop in prices occurs in a very short time period—usually followed by an equally rapid recovery. The blame for such incidents has been put on factors including human error as well as on computerized “black-box” trading programs that provide liquidity during calm market conditions but then seem to disappear during times of heightened market volatility. David Mann examines a recent flash crash in early October, and what this means in the context of exchange-traded funds (ETFs).

    Flash crashes have once again been in the news. One such incident hit the currency market on October 7 during Asian market hours; the British pound quickly sank more than 6% in a matter of minutes before recovering to settle down at a loss of around 1.5% on the day. The exact cause of the rapid selloff remains a mystery, although you can certainly Google the theories.

    Meanwhile, this summer equity markets passed the one-year anniversary of the flash crash of August 24, 2015, which saw the Dow Jones Industrial Average drop more 1,100 points in its first 15 minutes of trading. The anniversary of that event has rekindled discussions on market structure, namely what has changed to protect investors from further such incidents and what more can still be done. Many in the ETF industry have been eager to avoid a repeat of such incidents and have been vocal in terms of working with regulators to figure out how.

    Notably, there are generally three separate discussion threads when talking about flash crashes:

    1. What causes liquidity to disappear suddenly?
    2. What are the best practices for trading when entering an order into the market?
    3. What should regulators and exchanges do to protect those orders?

    Today we are going to tackle the first question – what causes liquidity to suddenly disappear?

    The price of an exchange-traded fund (ETF) is driven by the price of its underlying securities, in a similar way the liquidity of the ETF is driven by the liquidity of its underlying basket (as we discussed in a previous post). One of the reasons why many investors have gravitated toward ETFs is their daily transparency. That daily transparency lets ETF market participants know the fund’s exact holdings, which in turn allows them to price the ETF more accurately.

    To do their job effectively, ETF market participants need to be able to value the underlying basket of securities. If those securities are closed for trading in the US time zone (for example, international equity) or less liquid (such as fixed income), then they need to be able to value other correlated instruments to those holdings, such as equity index futures contracts, which can act as proxy vehicles for equity markets. When market participants are unsure of both of those values, it can lead to uncertainty regarding the price of the ETF, and potentially cause wider spreads.

    This was the case on August 24, 2015. There was a tremendous amount of uncertainty going into the market open given a selloff in China, and US-based stock index futures reached their overnight “limit-down” state—the maximum percentage drop before a trading curb or halt commences. Many US-listed stocks were slow to commence trading that morning once markets opened. Furthermore, those same US stock index futures that were limit-down before the open were near their limit-down state again. That uncertainty led to less liquid ETF markets, and ETFs that had an excessive amount of selling pressure experienced potential price dislocations (that is, assets are not correctly priced or are out of line with fundamentals during times of temporary stress) during that day.

    We often see this same dynamic play out to a lesser extent right before a Federal Open Market Committee Meeting when Federal Reserve (Fed) policymakers announce interest rate changes, as there is a tremendous amount of uncertainty in how markets will react. For example, in the seconds before the Fed announcement at its September policy meeting, some ETFs that were normally trading with a spread of around $0.01 to $0.03 with 1,000 shares available on the bid and offer widened. Once the news was digested (with no change in interest rates), the ETF markets returned to their normal spread and size.

    If an investor had tried to buy or sell a large amount of ETF shares in the seconds before the Fed announcement at what’s perhaps the highest level of market uncertainty, they may have experienced a “mini flash crash.” As I see it, the simple takeaway for investors is to consider avoiding trading when there are elevated levels of uncertainty, which is very different than trading during levels of heightened volatility.

    David Mann’s comments, opinions and analyses expressed herein are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.
    This information is intended for US residents only.

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    What are the Risks?

    All investments involve risks, including possible loss of principal. Brokerage commissions and ETF expenses will reduce returns. ETF shares may be bought or sold throughout the day at their market price on the exchange on which they are listed. ETFs trade like stocks, fluctuate in market value and may trade above or below the ETF’s net asset value. However, there can be no guarantee that an active trading market for ETF shares will be developed or maintained or that their listing will continue or remain unchanged. While the shares of ETFs are tradable on secondary markets, they may not readily trade in all market conditions and may trade at significant discounts in periods of market stress.