4 ETF Lessons From Knight
August 06, 2012
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After Knight lost a tremendous amount of money, it looked like it had stepped away from the ETF markets, and we published a back-of-the-envelope spot-check on how that might have effected ETF spreads. In that piece, I looked at noon spreads for the two days prior to last Wednesday, when Knight’s algorithms ran amok, and compared that with Wednesday’s and Thursday’s spreads. I commented at the time that my analysis was extremely quick-and-dirty, looking at just one spread point a day, and assuming it was representative.
We spent the weekend buffing that out, grinding through the actual moment-by-moment spreads on all of the NYSE ETFs for which there are lead market makers (about 1,000) over all of the last week. The results, unsurprisingly, broadly match up with our original findings. The spreads on less liquid ETFs (those trading fewer than 50,000 shares a day, on average) widened out in the wake of Knight’s issues.
We’ve done a few additional things here that are worth pointing out. First, based on this analysis, spreads on Knight LMM ETFs that already had low liquidity broadened out from 50 to 144 basis points during the crisis. However, by Friday, those spreads pulled way back in to 89 bps. From our analysis, this was not because Knight all of a sudden started making good markets.
Even this morning, a spot-check of the less liquid ETFs showed Knight still very far outside the current bids and offers. Instead, what we’ve seen is that other market participants—both market makers and regular traders—have noticed the spreads on these small-but-still-trading securities and have jumped at the chance to be the guy offering just slightly better prices than we saw before.
In the most liquid ETFs, the situation is generally unchanged. That’s to be expected, since they were essentially unaffected by all this kerfuffle in the first place.
So with things getting back to normal, I thought I’d address a few “lessons learned” from this experience.