When $1 trillion briefly evaporated from the U.S. stock market on May 6, no group of securities got hurt more than exchange-traded funds, as attempts to protect against snowballing losses may have made the decline worse, a report by federal regulators shows.
ETFs made up 70 percent of securities with trades that were later canceled because of excessive declines, the joint study by the Securities and Exchange Commission and Commodity Futures Trading Commission found. Traders selling the funds to offset falling stocks may have created “unusual liquidity demands,” causing buyers to pull out of the market, the report said.
“No question there’s a direct correlation because ETFs are the new derivatives,” said Richard Weiss, who helps oversee $50 billion for City National Bank in Beverly Hills, California. “The ability to arbitrage to ensure prices are fair is theoretically a very good thing, but when you get perturbations or exogenous variables acting on prices, it can be bad.”
While the study stopped short of assigning blame, its findings support a conclusion that fragmented markets and trading strategies fueled the chain reaction. The SEC yesterday proposed rules to halt trading in individual shares that swing more than 10 percent within 5 minutes to keep the selloff from recurring.
Regulators found no evidence that mistaken trades, terrorism or computer sabotage led the drop, which briefly sent the Dow Jones Industrial Average down 998.5 points. Instead, a “mismatch of liquidity,” selling in futures that fed into equities and orders to sell at any available price turned an orderly decline into a rout, the report said.
The Dow average fell as much as 9.2 percent on May 6, its biggest tumble since the crash of 1987, before closing down 3.2 percent. The Standard & Poor’s 500 Index fell 79 points in the 46 minutes after 2 p.m. and companies such as Accenture Plc and Exelon Corp. fell to pennies before rebounding minutes later. Those trades were later canceled.
Assets in U.S. ETFs, or baskets of stocks that can be traded like shares, grew 32 percent to $805 billion between the end of 2007 and March 2010, according to the Washington-based Investment Company Institute. By comparison, the total market value of the nation’s equities is down 28 percent from the high reached in October 2007, even after the 66 percent rally in the S&P 500 that began 14 months ago.
There are 1,003 ETFs listed in the U.S., according to data compiled by Bloomberg.
“ETFs as a class were affected more than any other category of securities,” according to the SEC and CFTC. About 160 ETFs temporarily lost almost all their value, while 27 percent of fund companies had securities with broken trades, it said. The agencies found that ETFs holding larger companies had the highest percentage of canceled trades relative to other types.
While price declines in individual stocks contributed to ETF losses, the agencies said hedging strategies may have worsened declines and led to some of the day’s biggest losses. For example, a trader trying to offset losses in a collection of individual shares might sell an ETF as a faster way to protect against market-wide declines.
Regulators are examining “the use of ETFs by institutional investors as a way to quickly acquire or eliminate broad market exposure and whether this investment strategy led to substantial selling pressure on ETFs as the market began to decline significantly,” the study said.
10 Trillion Bytes
Staff members of the SEC and CFTC compared hundreds of millions of records from May 6 totaling as many as 10 trillion bytes of computer data, it said. There were more than 17 million trades between 2 p.m. and 3 p.m. and 10.3 billion shares of NYSE stocks changed hands that day. By contrast, 600 million shares traded on the Big Board in the crash of 1987, the report said.
Absent from the report is a finding that the NYSE’s program for slowing the market, so-called liquidity replenishment points in which trading is switched to manual auctions, widened stock swings. Rapid-fire price changes trigger the LRP auctions, potentially encouraging electronic orders to flow to other exchanges with few if any offers to buy shares, said Larry Leibowitz, NYSE’s chief operating officer, on May 6.
“Some have suggested that LRPs exacerbated price volatility on May 6 by causing a net loss of liquidity as orders were routed to other trading venues,” the report said. “If accurate, this potentially could cause some NYSE securities to decline further than the broad market decline. Others believe that the LRP mechanism served to attract additional liquidity that helped soak up some of the excess selling interest. We are analyzing the effect of the LRPs closely.”
The report cites evidence that buying interest began to dry up as the selloff worsened in the 2:30 p.m. to 3 p.m. interval. Widening bid-ask spreads for E-mini futures, swings in volume from second to second and the behavior of traders who facilitate trading in futures markets, known as liquidity providers, suggest that demand decreased during the period, it found.
“Starting at approximately 2:35 p.m. liquidity providers began limiting their trading activity” in the Chicago Mercantile Exchange market for E-mini contracts, it said. “By 2:45:28 p.m., liquidity providers accounted for 46 percent of all transaction sides, lower than their participation percentage between 2:30 p.m. and 2:34 p.m. By 3 p.m., the liquidity providers accounted for 41 percent of transaction sides.”
Echoing the congressional testimony of CFTC Chairman Gary Gensler on May 11, the report cited sales of S&P 500 E-mini contracts by a single trader starting at about 2:32 p.m. on the day of the plunge. The trader “sold on the way down” and made up 9 percent of the volume during the period, the report said.
“Data from the CME order book indicates that, although trading volume in the E-mini S&P 500 futures was very high on May 6, there were many more sell orders than there were buy orders from 2:30 p.m. to 2:45 p.m.,” the report said. “Considerable selling pressure at this vulnerable period in time may have contributed to declining prices in the E-mini S&P 500 and other equivalent products such as the SPY,” or the SPDR S&P 500 Trust ETF, it said.
SEC Chairman Mary Schapiro and executives from the biggest exchanges, including NYSE Euronext and Nasdaq OMX Group Inc., agreed that all venues need uniform halts to shut down trading during investor panics. Circuit breakers proposed with the Financial Industry Regulatory Authority would be triggered in all markets by gains or declines of 10 percent over 5 minutes in S&P 500 companies, according to an e-mailed statement yesterday.
Instructions to sell stock at the available price known as market orders, as well as stop-loss commands that “turn into market orders” when prices are falling, may have worsened declines in the broader market. They could be banned or more strictly regulated, the agencies wrote.
The SEC and CFTC face pressure to show they have a grip on increasingly fragmented markets dominated by computerized trading of stocks and futures. Representative Paul Kanjorski, the Pennsylvania Democrat who leads the House panel, called hearings last week to scrutinize whether technology and competition for New York-based NYSE and Nasdaq contributed to the free fall in stock prices.
“The technology has advanced to the point where information can flow and be acted upon almost instantaneously,” said Weiss, City National’s chief investment officer. “What that means is that information, rumor and emotion including fear and greed can be embedded in stock prices almost instantaneously, and to some extent we saw that on May 6. So it’s incumbent on all of us and regulatory authorities to govern the implementation of that.”
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