• Avoiding disruptions on wild days said to be focus of talks
  • Exchanges, market makers part of effort to improve trading

The world’s largest issuers of exchange-traded funds are holding talks with stock exchanges and market-makers to avoid a repeat of the issues that plagued ETFs during Aug. 24’s market turmoil, according to five people with direct knowledge of the matter.

BlackRock Inc., Vanguard Group Inc. and State Street Corp., which between them manage close to $2 trillion in ETF assets, are among the money managers that have in recent weeks held discussions, according to the people.

On a day when about $1.2 trillion of U.S. market value had been erased before prices partially recovered, there were more than 1,000 trading halts, most of which were ETFs. Participants have highlighted several contributing factors, including the use of so-called stop orders by investors, the role of market makers in pricing ETF shares, and the narrow price bands used by the NYSE Arca exchange for opening and reopening securities that helped trigger multiple trading halts. The rules were put in place in response to the 2010 flash crash as a way to prevent extreme price moves.

“Everyone shoulders a little blame here: The exchange for its new rules, the market maker for overly-cautious spreads, the investor for putting in market orders at the open and the issuers for under-educating investors on how to trade these things,” said Eric Balchunas, an analyst at Bloomberg Intelligence.

Trading Halts

Of the 85 exchange-traded products that saw five or more trading halts that day, 79 were on Arca, according to data from Bats Global Markets. Much of that is due to Arca’s market dominance, with the exchange accounting for more than 85 percent of listed ETPs and more than 90 percent of total industry assets.

On Sept. 4, NYSE Arca filed with its regulator to widen how much prices could move during the opening minutes of trading. Under the new system, securities valued at 1 cent to $25 can rise or fall 10 percent from the prior day’s level. Those between $25.01 and $50 can move 5 percent, while stocks above $50 can move 3 percent. Previously, the limits were 5 percent, 2 percent and 1 percent, respectively. The exchange is considering whether to widen the bands for reopenings after trading halts, according to a person with knowledge of its plans.

Stacey Cunningham, chief operating officer at NYSE Group Inc., a unit of Intercontinental Exchange Inc., said last month that it has hired a consultant to review how ETFs trade on the company’s markets, including looking at trading halts. The effort will also try to assess whether brokers need better incentives to keep trading when markets turn choppy, she said.

‘Leadership Role’

“As the listing exchange for 94 percent of ETP assets, NYSE Arca has taken a leadership role in the dialogue, hosting a number of industry calls with ETP issuers, market makers and the retail community, and as a result, we have made changes on Arca while engaging the industry on broader market structure enhancements,” Steve Crutchfield, Head of ETPs, Bonds and Options at NYSE Group, said in an e-mail.

Industry talks have also looked at the role of market makers on Aug. 24 and how they priced ETF shares in a volatile market, especially when some underlying stocks weren’t open in early trading or were seeing wild swings. Ways to better calculate an ETF’s share price amid turmoil have been discussed.

Issuers and exchanges also believe that widespread use of stop orders by retail investors contributed to the volatility. The industry believes the orders, which instruct a broker to buy or sell if a security hits a certain price, exacerbated the moves. Two people said there have been discussions with brokers that offer stop orders about educating their clients on how to use them.

Stop Orders

While stop orders sound like they can protect an investor, they actually send an instruction to an exchange to execute a trade immediately at any price, commonly known as a market order. In volatile markets, that can mean orders to sell securities as prices are plunging. Data from NYSE show that it had nine times the number of market orders on Aug. 24 compared with an average day. Market orders as a percent of executed volume were four times higher than usual.

“ETF investors can avoid falling victim to these episodes by using limit orders, avoiding trading near the open, and -- if they simply don’t place any value on intraday liquidity -- they can attain many of the same exposures via low-cost index mutual funds instead,” Ben Johnson, director of global ETF research at Morningstar Inc., said by e-mail.

The U.S. Securities and Exchange Commission has asked the exchanges to find ways to fine-tune circuit breakers that halt trading of equities and exchange-traded funds during times of excessive volatility, said Stephen Luparello, director of the trading and markets division of the SEC, at a market-structure conference in Washington last week.

“Too many halts is as big a problem if not a bigger problem than not enough halts,” said Luparello.

Trading Curbs

SEC officials also are reviewing whether they should change curbs on how much prices are allowed to rise or fall on a given trading day due to concerns that those protections don’t work for ETFs, Commissioner Michael Piwowar said at a conference in September.

Noah Hamman, chief executive officer at ETF issuer AdvisorShares, said the industry could use the indicative value of the ETF’s shares to prevent wild swings and subsequent trading halts. The indicative value is a near-real time snapshot of the fund’s net asset value based on the underlying securities.

“You could look at the indicative value to identify trades outside of a certain range that may need to be canceled on behalf of any investor that may have received a bad price” he said by phone.

"As one of the largest ETF providers, we continuously support informing ongoing dialogues that help strengthen market infrastructure," said Brendan Paul, a spokesman for State Street, declining to comment on the specifics of ongoing conversations. John Woerth, Vanguard spokesman and Brian Beades, BlackRock spokesman, declined to comment.

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