The market tumult of 24 August 2015 saw hundreds of Exchange Traded Product (ETP) trades halted as equity prices plummeted rapidly. In response, the US Securities and Exchange Commission (SEC) is engaging with ETP sponsors, exchanges, and market makers to improve the functionality of ETPs in conditions of extreme stress. The proposals issued thus far will affect how ETPs are listed and traded on the exchanges going forward.
Even before trades were halted, ETPs were under the regulatory microscope. Earlier in the summer of 2015, SEC Commissioners and staff began looking at whether existing markets and exchange structures were adequate to support ETP trading. The agency had issued a Request for Comment in June, seeking public input regarding the exchange listing requirements and the arbitrage mechanism that helps ensure ETPs are properly valued and liquid.
Then, on 24 August, ETP trading was thrust into the spotlight again.
Ahead of the market open that morning, in an effort to improve trading efficiency during a period of extreme volatility, the NYSE invoked Rule 48, which exempted market makers from two key daily activities: having to make indications on a security’s opening price and to seek approval from exchange floor officials for that price. However, the absence of that information had the unintended effect of delaying the open for almost half of all equity positions listed on the NYSE. After days of increasing volatility, the Dow dropped more than one thousand points following the opening bell.
Selling volume, already high, increased as investors’ stop-loss orders were triggered, which put additional downward pressure on valuations. With delayed opens and heavy sell volumes, ‘circuit breakers’ were flipped as security prices dropped dramatically. These ‘circuit breakers’, or Limit-Up Limit-Down rules, resulted in trading halts across hundreds of securities, including three hundred twenty-seven ETPs. About 85% of all trade halts that day were related to ETPs.
Ironically, it was the Limit-Up-Limit-Down rules, instituted on a pilot basis as a safeguard following the Flash Crash of 2010, that were supposed to help manage market volatility by temporarily halting trading in securities experiencing extreme price movements.
PROPOSED RULE CHANGES
By September, nearly forty market participants, academics, observers, and plan sponsors had given the SEC written comments on the issues surrounding ETP trading. Also in September, the SEC issued proposed rules and amendments that would force open-end mutual funds and ETPs to take additional steps in managing their liquidity risk. Then, in November, the NYSE filed a proposed rule change with the SEC that would tighten the spreads in its existing ‘aberrant’ trading rules.
As expected, ETP sponsors, the exchanges, and regulators have differing views on the potential changes. Many sponsors would prefer that the changes be applied consistently across all listed security types, be they ETPs or individual equities. However, the recent NYSE proposal to tighten spreads in its existing ‘aberrant’ trading rules would effectively apply different spreads to different security types. Exchanges and regulators are being called upon to review the ‘circuit breaker’ rules and improve their current structure to:
- Ensure consistency in pricing bands throughout the day, as opposed to wider bands at the open and close
- Examine a market-wide circuit breaker that could be flipped in periods of extreme volatility
Due to the unintended consequences presented by Rule 48, many ETP sponsors are also seeking further automation of some practices at the exchanges, specifically regarding pre-open information delivery.
MORE CHANGES AFOOT
The SEC recently issued its post-mortem on the 24 August events. While the report did not provide additional proposals, this was only the regulator’s first step and additional changes are on the way. It is critical for ETP sponsors and market makers to weigh in on these discussions. Any changes to the current ecosystem will likely have an impact on how ETPs trade, and will require closer coordination between sponsors’ capital markets desks, the exchanges, market makers, and authorized participants. Communication between these parties is paramount to support a properly functioning ETP market. The trading halts put tremendous strain on the sponsors distribution and client service teams. Sponsors should examine how they deliver information to their clients during these events.
It is clear that the SEC and exchanges have different approaches and possible solutions to consider. Given these proposals, as well as the SEC’s proposed increase in derivative oversight (announced in December) 2016 will present a number of regulatory changes that ETP sponsors need to review.
This article was originally published in the 2016 Regulatory Field Guide. The guide features insights from a number of our experts on key regulatory developments that will have the greatest impact for asset managers in the year ahead – and beyond. Visit bbh.com/regulatoryfieldguide to explore the guide.