Exclusive: Market Regulators Probing Chaotic ETF Trades

Should market regulators ride to the rescue and cancel problematic trades in exchange-traded funds that plunged in Monday's mayhem, just as they did other trades after the flash crash of 2010?

Officials at the Securities & Exchange Commission and the New York Stock Exchange say they are looking into the issues surrounding massive ETF price plunges on Monday, as traders, investment bank executives, and analysts warn that the retail investors’ confidence in the market just got rocked.

But the answer so far as to whether problematic ETF trades on Monday will be cancelled is no, according to interviews with market officials.

The irony is, new rules enacted after the flash crash of 2010 provide plunge protection in the markets and therefore, because of those rules, no trades will be cancelled, market officials say, “regardless of whether trades are erroneous,” according to one exchange executive. But those same rules are being blamed by traders and fund officials for the market chaos in ETFs.

A NYSE official now tells FOX Business: the "whole market is looking at how Monday's sell off hit ETFs, and the combination of factors that caused significant price swings, to ensure it [problematic trading] doesn't happen again."

An SEC official tells FBN: “We care that the standards are known to all well in advance,” adding, “we are obviously looking at what works effectively and efficiently, we are keenly focused on the limit-up/limit-down rules, to see if they were a help or hindrance” in Monday’s action.

However, the NYSE official says that there were “no busted trades,” and no ETF trades will be cancelled.  Nasdaq’s director of corporate communications, William Briganti, says: “We have no current plans to cancel any ETF trades from Monday.” An official with the Financial Industry Regulatory Authority says it is aware of the issue as well.

Many of the biggest and most popular exchange-traded funds owned by the little guys, the same ETFs touted on TV ads, saw colossal price swings in the chaotic minutes after Monday's opening bell, with prices plummeting 20%, even nearly 40%. Many funds saw their prices drop below the values of the indexes the ETFs are designed to track, even below the prices of the ETF's underlying stock holdings.

The ETF controversy comes as these funds hit a record $2.93 trillion in assets last March, according to data provider ETFGI. ETFs are investment funds that trade on the stock exchanges. The majority are built to track major indices, like the S&P 500. Earlier this year, PricewaterhouseCoopers released analysis showing ETFs are on track to grow to $5 trillion in assets by 2020.

When the bell rang Monday morning at 9:30 a.m., ETFs rapidly started plunging.  The iShares Select Dividend dropped about 31%, the Vanguard Consumer Staples ETF sunk 24%, and the SPDR S&P Dividend ETF plummeted 35%, but in an hour rocketed back up. Powershares QQQ, which follows the Nasdaq 100, dove nearly 15%.  The Vanguard Dividend Appreciation ETF dropped about 25%. Meanwhile, the net asset value of the underlying stocks in some of these ETFs fell only 6% to 7%.

"We are a bit bothered by the extent of 'flash' dislocations in many large cap stocks and especially by huge disconnects (albeit brief) between several major broad market ETFs and their underlying indices,” David Bianco, chief U.S. equity strategist at Deutsche Bank (NYSE:DB), said in a research note Tuesday. “Corrections are never orderly, but this is a blow to both institutional and individual investor confidence.”

Economist Ed Yardeni agrees: “ETFs contributed to the recent debacle. There were mini flash crashes in many ETFs because liquidity dried up as market makers and broker-dealers had no idea what a fund’s holdings were really worth.”

The fund industry was thrown into even more chaos after Bank of New York Mellon (NYSE:BK) said a computer glitch on Monday prevented it from promptly posting prices for certain mutual funds and ETFs. The world’s largest custodial bank moved quickly to fix the snafu, and is clearing it up.

A number of things came together to create a perfect storm on Monday. Trouble began before the 9:30 a.m. open, when stock-index futures were eroding fast. That triggered trading halts, where trading was stopped in certain securities.

Seeing the futures dropping more than 700 points before the open, the NYSE also declared an “extreme market volatility condition” and activated “Rule 48” to try to ensure smoother trading. The rule, approved by the SEC on Dec. 6, 2007, gives designated market floor managers the discretion not to announce price indications before stocks open, the idea being that a pause will make it easier and faster to open stocks.

But market players tell FBN the moves actually heightened the lack of transparency and uncertainty about the stock prices in the ETFs. With many stocks not opening, market makers, or broker dealers who put up the capital for trades, couldn’t adequately price ETFs, and instead backed off the trades, causing bid-ask spreads to widen.

By mid-morning, trading of U.S. stocks and exchange-traded funds was halted more than 1,200 times as the market whipsawed through heightened volume and volatility. The trading rule that was invoked is also being blamed for the pandemonium in ETFs.

Called limit-up/limit-down, the rule was approved by the SEC in May 2012, two years after the flash crash of 2010. But the rule actually helped aggravate the chaos, traders and fund officials say. The rules are trading restrictions that are meant to let stocks trade in specified ranges vis a vis a reference price.

The SEC says the rules are “intended to prevent trades in individual securities from occurring outside of a specified price band. This price band would be set at a percentage level above and below the average price of the stock over the immediately preceding five-minute trading period.” The rule stopped trading for 15 minute pauses during Monday’s action.

A market official says when it came to the broker dealers handling these ETF trades, “for a market maker for an ETF, to think he would have to sit for 15 minutes on that level of risk, that’s a big risk appetite for them. They’ll question whether to even make a market in that ETF, and then whether they are willing to put up their own capital to back that ETF. So they back off. Market makers also said, ‘we wanted to buy as much as we could, but internal company constraints on the use of company capital restricted them, too. All of that caused spreads to widen.”

But because of the so-called anti-volatility rules, the ETF trades likely won’t be cancelled, market officials say.