Now that the markets have taken the time to dissect the exchange traded fund mini flash crash during the height of the recent volatility, investors may better understand how the players behind the scenes orchestrate a well choreographed dance to keep ETFs working.
According to a recent KCG research note, Phil Mackintosh, Ka Wo Chan and Rachel Lian point to three lessons that market observers may have taken away from the recent fallout: A continuous market with consistent and predictable hedging and pricing data is essential for liquidity providers. Market and stop-market orders provided no price protection and may have contributed to feedback loops. Lastly, ETFs may need single stock limits using a collar around their net asset value, instead of rolling average prices. [ETF Boot Camp Poised to Dissect Mini Flash Crash]
On August 24, the volatility fueled an overwhelming percentage of sellers flooding the markets. Meanwhile, interconnected markets experienced inconsistent rules around trading halts, which affected market liquidity. Along with the trading halts, the late New York Stock Exchange open also contributed to the reliability of pricing sources used to value derivatives. [What Happened with ETFs on Monday’s Mini ‘Flash Crash’]
Consequently, ETFs experienced some of the most severe price declines as market makers struggled to price derivatives due to uncertainty over tradability and pricing of hedges, according to KCG.
Market makers help create or redeem ETF shares as a way to keep an ETF’s price in line with its net asset value. With many stocks being halted shortly after opening Monday morning, the diminished transparency into prices may have affected market makers’ ability to calculate at what price to step in. Consequently, market makers stepped out of the way, allowing the market to price in orders before they were able to set their own prices, and waited for more precise numbers to come in.