By Olivier Ludwig
Don’t listen to the ‘nattering nabobs of negativism’ when they say the ETF was to blame for the flash crash of May 6. The way I see it, it was a raucous coming-out party for the security of the future.
It may be tempting to look for the easy storyline and argue that exchange-traded funds have some fatal flaw just because about two-thirds of the more than 300 securities with canceled transactions that day were ETFs. But it’s also wrongheaded. Investigators still don’t know exactly what went wrong that day except that lightning-fast electronic trading was at the center of it and, to that extent, so was the ETF.
The ETF is a creature of a modern era characterized by ubiquitous use of computers and globalization. I can hardly think of a security that’s more dialed in to the algorithmic, black-box trading system that became unhinged on May 6 than the ETF. And, in general, ETFs did exactly what they’re supposed to do that day. If the flash crash taught us anything, it’s that the centrality of the ETF in that day’s craziness means that the ETF is here, and it’s here to stay. It’s time we deal with that reality, and the flash crash also provided clear evidence that we haven’t.
Looking back to May 6, it was quaint that the New York Stock Exchange stepped in and tried to slow things down. It was the right idea, but fell far short of the mark. After all, the days of the Big Board dictating anything on Wall Street are long gone. The system of using specialists to match buyers and sellers is an anachronism that’s analogous to using bows and arrows to fight a mechanized army that uses laser-guided bombs. It doesn’t mean that bows and arrows are inelegant tools, or that laser-guided bombs are without collateral damage. It does mean that they’re archaic and impractical.
The NYSE now shares the roost with a host of electronic exchanges, including Nasdaq and BATS, to name the biggest. It was the blind leading the blind on May 6. And that led to those crazy prices—some less than a penny—as computers interpolated a delusional semblance of fair value in the face of an unprecedented deluge of selling pressure. Clearly there’s a better way.
The good news in all this is that regulators in Washington, D.C. seem to get what’s going on. They’re taking a wide-angle look at the events of May 6, starting with combining resources at the Securities and Exchange Commission and the Commodity Futures Trading Commission to study the problem in a systematic way that leaves no stone unturned.
Recognizing that electronic trading was at the center of the market whipsaw that day, regulators are keen on unifying the rules among the different exchanges so that the next time trade becomes dislocated, as it inevitably will, all the important players will be using the same playbook to restore calm. They also aim to find out why the ETF was affected more than any other security (hint: because arbitrage is at the core of nearly all lightning-fast algorithmic trading, and ETFs are all about the arb).
Still, it’s a worthy cause, because the ETF is everything a mutual fund is, and a whole lot more. They’re offspring of the indexing revolution, so they have better returns and are a lot cheaper than most mutual funds. And have you heard about the tax advantages of owning ETFs? (Also, see Paul Weisbruch's interview here).
While legends of the money management industry like John Bogle can’t stand how trader types are buying and selling ETFs like stocks, thus corrupting the ETF’s virtues as the bright new face of indexing, I’d give an “A+” to regulators so far in their efforts to find a better way for markets to safely do what they will with a security that’s not going away.