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ETFs, Market Instability, and Arbitrage

The SEC has yet to come up with a fully credible explanation for the flash crash, although they have done an excellent job of organizing the data and describing what happened to the individual stocks and ETFs during the 5 minute horror show. Mary Schapiro, after noting the retail investors whose stops were blown probably lost 200 million dollars, has yet to identify any responsible parties.  Here is one place I would look, very carefully:

It is possible, and indeed necessary to an efficient market, to arbitage between ETFs and their constituents. During the market crash, ETFs were far and away the most unstable items traded, and many of them plunged to the .01 stub quotes. Market makers, or their modern day equivalents, stood aside.  Those who were obligated to provide quotes did so by posting meaningless stub quotes, .01 bid and 10,000 ask. 

Suppose a manipulator found a way to destabilize ETFs. That would create a perfect way to reap guaranteed profits by trading the mispriced ETF against its constituents.  A minor perturbation, if done several times a day, might yield predictable profits. 

Of course, there is no such thing as moderation on Wall St.  The perpetrators got greedy, overdid the perturbation, and the result was the minicrash. 

A careful study of the weeks leading up to the crash, focusing on who made money out of mispricing on ETFs vs. their constituents, might develop factual support for this theory.

Disclosure: No positions mentioned