A Meditation On Mini Flash Crashes
May 06, 2011
Page 1 of 4
The flash crash of May 6, 2010 occurred exactly a year ago, and while a repeat hasn’t materialized, a number of less broad, but similarly startling, price dislocations have occurred in several ETFs in the past few months.
First there were 10 FocusShares ETFs that became unhinged in late March—on their second day of trading. At least one of the funds was driven down to a penny a share in the episode, inviting comparisons to the actual flash crash. Then, about two weeks later, the iPath Optimized Currency Carry ETN (NYSEArca: ICI), a security as thinly traded as FocusShares’ new equity ETFs, shot up into the stratosphere. The exchanges subsequently canceled the “clearly erroneous” trades, just as they did after the flash crash.
The affected exchange-traded products in both of these episodes had low trading volume, and the irregular trading began with market orders. Both of these facts are important, and I’ll return to them later.
What’s rarely mentioned in the media accounts about these ETF “blow-throughs” is that they occur regularly for common stocks as well. I’ll give credit to the New York Times for publishing an article in September discussing “mini flash crashes” in Apple Computer (Nasdaq: AAPL) and the Washington Post (NYSE: WPO), among others.
The article, in fairness, didn’t mention ETFs, simply because such mini flash crashes are related to nuances of electronic trading and market-structure regulation rather than to some intrinsic flaw with the ETF structure. This is likely to be bad news for the anti-ETF pundits because they’ll have to find another product to misrepresent. The simple truth is the ETF structure remains one of the greatest financial products ever developed.
If we look more closely at the development of electronic exchanges, the rules that govern them and how investors and financial intermediaries interact through various order types and processes like high-frequency trading and algorithms, it’s easy to see how these periodic “blow-throughs” occur.
There’s nothing in the structure or use of ETFs that causes these events, but rather, there are systemic issues with equity trading that have existed in the markets for decades. These events may at times be unintended or inevitable because of new regulations, new technologies or human error. While exchanges and regulators have made great strides to reduce the occurrence and impact of these events, completely preventing them is difficult. That said, more work needs to be done, especially on ETFs.
Every Convenience Brings Its Own Inconvenience
The U.S. equity markets continue to evolve and, by definition, toward greater efficiency. This evolutionary process in the stock market is due to advancements in technology and communication coupled with regulatory changes.
This was evident as markets moved off of floor-based exchanges and into electronic exchanges. The move wasn’t made because we suddenly found new technology, but because financial events and the obligation of regulators and exchanges to protect investors created the need for change.
The stock market crash in 1987 is a great example. A large concentration of sell orders in the futures market create a massive selling in the equity market, and the Dow Jones industrial average fell more than 600 points in the last few hours of trading on Oct. 17, 1987.
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