ETF Capital Markets Desk: It’s Time to Talk about Market Orders

Why aren’t ETF market orders doing what they were designed to do anymore?

    David Mann

    David MannHead of Global ETF Capital Markets,Franklin Templeton Investments

    Is a new definition of “market order” in order? David Mann, our Head of Global ETF Capital Markets, shares his thoughts. He explains how market orders have changed—and why they aren’t doing what they were originally designed to do anymore.

    In my last post, I expanded on some earlier thoughts about bid/ask spread misconceptions.

    ETFs with similar underlying baskets tend to trade at similar premium/discounts to net asset value (NAV)1, irrespective of the bid/ask spread at the time of trade.

    I also mentioned that bid/ask spreads matter when investors use market orders, the definition of which I’ll get to in a bit. The tighter the spread (as well as more size on the bid/offer and increased depth of book, or pending orders), the less likely a market order will execute at a price disconnected from the current market.

    As it stands today, this is really a simple math exercise; if the size of the market order is greater than the size in the market, “bad” trades might occur. For simplicity’s sake, I would define a ‘bad’ trade as any trade that occurs at a disconnected price from the current market.

    This has led to two main soundbites within the ETF industry, neither of which I like:

    1. ETF issuers advising investors not to use market orders, especially in newer ETFs. I admit—I do this as well.
    2. Investors—especially those who use market orders—will only use high-volume ETFs in order to avoid any possible liquidity concerns.

    Market orders are not supposed to be scary!! So what exactly happened? My answer:

    The definition of “market order” has changed!

    To understand why market orders have changed, let’s go back to the days of the American Stock Exchange (AMEX), which also happens to be where I started within the ETF industry 16 years ago. This was before the implementation of Reg NMS in 2005. At a high level, an ETF would list on an exchange like the AMEX where there would be a specialist in charge of overseeing the order book in that fund.

    Market orders would be sent down to the specialist who (along with the traders in the crowd) could trade the order as long as it matched or beat the best market at the other exchanges. Otherwise, the trade would get routed to the exchange with the best market.

    Let’s set aside for now any discussion on speed and technology and instead focus on what it meant to send a market order back in 2003.

    Here is my 2003 definition of a market order: “An order to buy or sell shares at current market levels where the specialist and floor traders at the listing exchange will determine the final execution price.”

    As mentioned earlier, Reg NMS came along and changed the entire trading ecosystem. Once again, I do not want to get into the market structure weeds for this post. However, for ETF trading, now everything is electronic without a dedicated floor specialist. Liquidity is fragmented across multiple trading exchanges.

    Here is my 2019 definition of a market order: “An order to buy or sell shares at current market levels where the order is continuously routed to the exchange with the best price until the order is complete.”

    The spirit of the market order is for it to get filled at current market levels. Sixteen years ago, that order would go to a person whose job it was to fill that order at current market levels. Today, the order is handled by a machine that looks for liquidity no matter the price, even if it is multiple percentage points away from the original market.

    The result is now many investors are either 1) scared of market orders in general or 2) avoiding low-volume ETFs because of their concerns that a market order could go haywire.

    Before I continue, I should say that this article is not meant to criticize Reg NMS or recommend we go back to the floor model of 2002. It is also not meant to make any bigger points of man versus machine when it comes to trading.

    My point is we need to acknowledge that given the current market structure environment in the United States, “market orders” are not doing what they were originally created to do. These orders need to be updated to match existing market structure, and that is what I am going to discuss in my next article on this topic.

    ENDNOTES

    1. Net Asset Value (NAV) represents an ETF’s per-share value. The NAV per-share is determined by dividing the total NAV of the Fund by the number of shares outstanding.