Would ETF Circuit Breakers Do Harm?
July 15, 2010
Worries about unintended regulatory consequences are coursing through the trading community as the day fast approaches, perhaps as early as next week, when the Securities and Exchange Commission implements new rules on ETF trading.
The rules, which amount to an attempt to prevent a repeat of the “flash crash” on May 6, would expand the SEC’s pilot stock-by-stock circuit breaker program from its current scope covering stocks on the S&P 500 Index to include 344 ETFs. Under the program, trade is halted in a stock that moves more than 10 percent in five minutes.
There’s a sense among some market participants that the expanded rules ought to be refined before they’re implemented because they could end up destabilizing financial markets if their effects are more like a sledgehammer than a scalpel, according to some of the public comments on the SEC’s Web site.
Peter Skopp, chief executive officer of Molinete Trading, a Miami Beach, Fla.-based proprietary trading firm, said in his public comments that under the SEC’s proposal, trading in the SPDR S&P 500 ETF (NYSEArca: SPY) “would have been erroneously halted twice in the past 18 months, potentially destabilizing the markets.”
One of the problems, according to Skopp, is that the SEC’s proposed rule would stop the tape on some of the most heavily traded ETFs based on a single bid or ask that is 10 percent or more away from the last good sale.
“If one of those really liquid, high-volume ETFs were halted, then certain market participants who use them as hedging vehicles might withdraw from the marketplace,” said Skopp in a telephone interview. The evaporation of liquidity amid a deluge of selling was one of the principal culprits in the “flash crash.”
IndexUniverse.com Research Director Dave Nadig voiced a related concern in his recent podcast, saying if ETF circuit breaker rules caused heavily traded ETFs such as SPY to shut down too frequently, trade could actually migrate to other venues, such as competing ETFs or the over-the-counter derivatives market.
"What you end up with is this whole potential for chaos by freezing up these funds as opposed to individual securities,” Nadig said.
Also, Skopp’s not alone, based on IndexUniverse.com’s perusal of the public comments.
Sal L. Arnuk and Joseph Saluzzi, the co-founders of Chatham, N.J.-based Themis Trading, also pointed to the possibility for mischief under the SEC’s proposed rule. “Every trader in the world that has the ability to print a trade on a trade reporting facility (TRF) now has the power to halt a stock,” they said in their public comment.
The 10-day public comment period for the proposed rule, which was published in the Federal Register earlier this month, ends on Saturday, July 17.
Once the public comment period is over, the SEC typically takes additional time to review and deliberate before implementing a proposed rule, a spokesman at the commission said. Those deliberations sometimes lead to significant changes to the rules as they existed during the public comment period.
A Long Process
Beyond the concerns voiced on the SEC’s Web site, some say there’s no getting around that the issues involving circuit breakers are complex and will take time to completely address.
“I think they’re doing everything they can do given the environment and resources,” said Richard Keary, president of Global ETF Advisors LLC, a New York-based firm that helps clients bring exchange-traded products to market.
“The thought process is right—getting these circuit breakers in and testing them and making sure they work before they start getting into the more complex structures like an ETF,” Keary said. “You know—get it right, the first time out, with the core equity securities, and then move that process over to ETFs to see if those rules need to be tweaked for ETFs.”
Keary, laying out one what-if scenario that went to the heart of the complexity regulators are grappling with, said investors holding a single-country emerging market ETF face unique challenges that make the circuit breakers seem inadequate.
Such ETF holders could enter a world of financial pain if the underlying securities in the fund were selling off sharply while trade in the ETF was halted after the 10 percent threshold was crossed. That could mean they’d have to wait until the following session to sell—by which time the ETF might just open 10 percent lower, giving them no chance to exit their positions before their losses doubled.
“I think we’re at the start of something, but there’s still a ways to go,” Keary said.