Periods of heightened market volatility frequently present questions regarding the structure and liquidity of exchange-traded funds (ETFs). Taking a closer look at ETF trading during February’s market correction, we see evidence that improved regulations and better exchange structure have strengthened ETFs, enabling them to provide the liquidity investors need without setting new obstacles to trading activity during times of market stress.
The flash crash of 2015 and the regulatory response
The sharp market decline of August 24, 2015, which saw more than 1,000 trading halts on stocks and ETFs in a single day, drew considerable attention to some of the structural features of ETFs. In the aftermath of that market event, regulators, issuers, leaders of securities exchanges, and market makers sought to devise more robust methods for ETF trading mechanisms in times of market turbulence, as well as new strategies for making single-stock and ETF trading less vulnerable to extreme market volatility.
Regulatory changes made after August 2015 were aimed at the interior market structure of ETF trading, and they effectively addressed potential loopholes that otherwise led to pricing dislocations in prior periods of market stress. Some of the more important changes included:
- Elimination of stop and good ‘til canceled (GTC) orders: These order types were all too frequently landing ETF investors in trouble, as extreme volatility turned these risk-management tools into loss-producing trades.
- Harmonization of exchange rules: Bringing trading rules into alignment, including rules for triggering marketwide circuit breakers on the NYSE, BATS, and NASDAQ, helped bring more transparency and rigor to a variety of exchange procedures.
- Improved limit up/limit down (LULD) and trading collar strategies: These features were designed to reduce the frequency of trading halts.
- Improved ETF reopening procedures: With cross-exchange parity on ETF reopening rules following trading halts, the potential for wild price swings was substantially reduced.
As a result of those efforts, today’s ETF ecosystem is stronger than ever.
The February 2018 correction: historically large trading volume in a small number of funds
On February 5, 2018, as the Dow took a nose dive of more than 1,000 points, estimates indicate that $250 billion of the $631 billion that traded on U.S. exchanges was traded in ETFs. During the final two hours of trading that day, estimated ETF trading volumes surged to more than $100 billion per hour. On average, only about six to eight ETFs trade more than $1 billion in volume in a given day, but between February 5 and 7, more than 31 ETFs traded more than $1 billion per day.1
ETFs typically account for anywhere between 27% and 30% of the daily value traded on U.S. exchanges, but in the first week of February 2018, ETFs accounted for more than 40% of the notional dollar value traded on U.S. exchanges.2
Despite the pickup in the number of funds providing higher liquidity in February’s market correction, the vast majority of this liquidity was delivered through a relatively small number of funds. Approximately 50 ETFs accounted for more than 90% of the intraday trading in U.S. markets in the first week of February 2018. This suggests the vast majority of available ETFs—with more than 2,000 available to U.S. investors today—are used as buy-and-hold vehicles, whether for some combination of transparency, cost effectiveness, and tax advantages, and are not purchased exclusively for their intraday liquidity potential.
What’s more, ETFs appeared, even under the close scrutiny of federal policymakers, to be blameless for the market’s gyrations. In his late February testimony to the House Financial Services Committee, new Federal Reserve Chairman Jerome Powell stated, “We looked after the volatility came and then subsided. We looked carefully to try to understand what did happen, and it seems like the markets were generally orderly through almost all of that time … and I don’t think [ETFs] were particularly at the heart of what went on.”
Record liquidity without a hitch
The important takeaway from the February surge in ETF trading activity is that although a historic amount of liquidity—with some estimates exceeding $2 trillion—was provided to investors through ETFs in a single week, this unprecedentedly swift movement of such substantial capital didn’t cause the markets to break. ETFs experienced no flash crash or avalanche of trading halts, despite the fact that trading velocity had accelerated to historic highs.
In other words, ETFs acted exactly as they should have during the most volatile trading period in more than six years: They provided record levels of intraday liquidity with no major market structure challenges. But for all their intraday liquidity potential, particularly in volatile markets, we note how much of this market segment remained static and untapped for liquidity objectives. Even as the velocity of trading increased, the vast amount of ETF assets stayed put, contrary to common perceptions, but right in line with the growth of ETFs as buy-and-hold investment options.
1 Bloomberg, Virtu Trading, Deutsche Bank, 2/13/18.
2 Bloomberg, 2/13/18.