The U.S. Senate held a sub-committee hearing on Wednesday, Oct. 19th, to discuss the role that ETFs might be playing in driving market volatility and even in posing risks to the stability of the financial system.

Noel Archard, a managing director at the world's-biggest ETF firm iShares, and Harold Bradley, the chief investment officer at the non-profit Kauffman Foundation, were among those testifying at the U.S. Senate Banking sub-committee hearing, “Market Microstructure: Examination of Exchange-Traded Funds (ETFs).”

Kauffman's Bradley is the co-author of two recent research reports that took a critical view of ETFs, suggesting they represent a risk to the functioning of modern equity markets. The stakes are high, as assets in U.S.-listed ETFs now total more $1 trillion and are growing rapidly, according to data compiled by IndexUniverse.

Also on the panel were NASDAQ’s Eric Noll, an executive at the exchange in charge of transaction services, as well as Eileen Rominger, the director of the Securities and Exchange Commission’s Investment Management division, the Senate said on its website.

The hearing takes place at a time of wild fluctuations in the stock market and lingering concerns that another “Flash Crash” may be possible. Many are questioning whether ETFs – particularly leveraged and inverse ETFs – are playing a crucial role in driving increased market volatility. Others worry that short-selling in the ETF market represents a systemic risk to investors.

A source at the Senate subcommittee told IndexUniverse in an e-mail that the hearing will include examination of the following ETF-specific questions:

• Do ETFs affect market volatility?
• Do leveraged and inverse ETFs affect market volatility differently than other ETFs?
• Do ETFs present systemic risks to the financial system?  Why or why not?
• What factors have influenced ETF growth since their emergence in the early 1990s?
• How have investors been impacted, directly or indirectly, by ETFs?
• What international issues affect the domestic ETF marketplace?
• What changes or improvements, if any, can or should be made to ETF regulation?

The Dark Underbelly Of Reg NMS

Some say that a good part of the market instability and volatility can be traced back to Regulation NMS, which the Securities and Exchange Commission established in 2007 to account for the growing importance of electronic trading, and to ensure healthy competition among individual markets and the fairest possible prices.

“Reg NMS” has, without question, democratized access to markets and narrowed bid/ask spreads -- the price gaps between what buyers are willing to pay and what sellers are willing to receive for a given security.

But Reg NMS has also been blamed for fostering instability. That's because the rule dispensed with the responsibility market makers had to maintain trade, even at times of great volatility. So-called specialists used to control order flow and maintain liqudity as they plied trading floors in places like the New York Stock Exchange.

These days floor specialists are relics of a past that mostly no longer exists, and a multitude of electronic exchanges have toppled the NYSE from its once-dominant position in the world of equity trading.

More to the point, today's market makers, unlike the specialtists of the past, have no incentive to keep orders flowing, depriving markets of liquidity when they truly need it, as was the case during the Flash Crash of May 6, 2010.

The Effects Of The Flash Crash

Regulators at the SEC have been hard at work grappling with questions about market structure and leveraged ETFs for more than a year, particularly in the aftermath of the Flash Crash.

On that day, the Dow Jones industrial average fell 10 percent in the space of minutes, only to rebound as quickly and close about 4 percent lower. The entire episode began around 2:30 p.m. Eastern time and was over in less than 30 minutes.

The day began with Molotov cocktails flying in the streets of Athens and traders on tenterhooks, underscoring an important aspect of volatility: namely that nothing puts markets on edge more than uncertainty.

That's an ingredient that has been in ample supply since two Bear Stearns hedge funds went up in smoke in June 2007, arguably marking the beginning of a global financial crisis that has yet to fully play out.

Still, to the extent that ETFs now make up about a third of all U.S. equity trading, they are at the center of discussions about market structure. Moreover, about two-thirds of the securities with canceled trades in the aftermath of the Flash Crash were ETFs.

Indeed, some are now questioning whether ETFs – most recently, leveraged and inverse ETFs, in particular -- are playing a more crucial role in volatility than market structure or global macroeconomic circumstances.

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