The August Of Our Discontent

The current volatility debate centers on four consecutive days of several-hundred-point price swings in the Dow Jones industrial average.

All this crazy trading was precipitated by the downgrading of U.S. debt for the first time in our history along with complete dysfunction of the U.S. and European political system in a time of financial crisis. With a political class that seems out of its depth in terms of clarity and decisiveness, it’s totally unsurprising that financial markets freaked out.

And regulators are blaming ETFs? That’s crazier than the real reasons markets have been so unsettled.

Add to that deficient market structure rules that allow for trading in nanoseconds with no regulation on how high-frequency traders access the markets, and I become amazed we saw only four days of market gyrations.

At the center of the current market structure are participants who have no incentives to stand in front of a freight train full of sell orders like we saw in August and take on the market risk associated with being the buyer of last resort.

And who can blame them? It’s not their function to bear the brunt of massive order imbalances. In such times, liquidity temporarily leaves the market, the herd mentality prevails and volatility will rear its head, whether or not there are ETFs in the market.

And the SEC is launching an inquiry into ETFs? Give me a break.

To Regulate Or Not To Regulate

Regulators, government officials and exchange executives have a choice to either implement new rules when new technologies and new types of market participants enter the market or to let private enterprise find the solutions.

Since 2007, letting private enterprise find solutions to problems that Reg NMS either didn’t anticipate or didn’t address hasn’t really worked out. Clearly, there’s a need to set a standard of behavior for high-frequency traders that protects investors and the markets.

The SEC began this discussion right after the flash crash in May 2010. It talked about creating obligations for high-frequency traders that were equivalent to the obligations of other market participants, basically leveling the playing field. By now, it seems like it’s been nothing but talk.

When we watch the market fall 100s of points in the last 15 to 30 minutes of trading, why are we blaming ETFs, which trade throughout the day and thus reduce end-of-day volatility by giving investors access to the market throughout the trading day?

If you want to reduce market volatility, don’t blame ETFs, use ETFs!

The correlation between inverse and leveraged ETFs and market volatility simply doesn’t exist. Let’s move away from these witch hunts and take actions that allow our market structure and pricing mechanisms to withstand the ever-changing market events that have always been the root cause of volatility.

Richard Keary is the founder of Global ETF Advisors LLC, a New York-based firm that offers advisory services that help clients bring ETFs to market. Keary also spent seven years at Nasdaq, where he helped build Nasdaq’s Market Intelligence Desk, and created and built Nasdaq’s ETF listings business.

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