Exchange Traded Funds Market Structure and the Flash Crash 5

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www.cfa pubs .org

?2012 CFA Institute

Financial Analysts Journal Volume 68 x Number 4?2012 CFA Institute

Exchange-Traded Funds, Market Structure, and the Flash Crash

Ananth Madhavan

The author analyzes the relationship between market structure and the flash crash. The proliferation of trading venues has resulted in a market that is more fragmented than ever. The author constructs measures to capture fragmentation and shows that they are important in explaining extreme price movements. New market structure reforms should help mitigate such market disruptions in the future but have not eliminated the possibility of another flash crash, albeit with a different catalyst.

he “flash crash” of 6 May 2010 represents one of the most dramatic events in the his-tory of the financial markets. Late that after-noon, major U.S. equ ity market indices

began to decline sharply. The Dow Jones Industrial Average (DJIA) dropped 998.5 points, the sharpest intraday point drop in history, followed by an astounding 600-point recovery within 20 minutes.The flash crash is distinguished from other market breaks—su ch as the one in October 1987—by its speed and rapid intraday reversal. Unlike other sharp intraday market breaks, such as the one on 28 May 1962, multiple securities traded at clearly unreasonable prices, including some (e.g., Accen-ture, 3M) that traded for pennies. Also notable was the disproportionate representation of exchange-traded products (ETPs) among the securities most affected, with prices diverging widely from their underlying net asset values.

Despite its short du ration, the flash crash affected many market participants. Exchanges ulti-mately canceled trades at prices below 60% of the 2:40 p.m. (EDT) price, bu t many retail investors with market stop loss orders still had orders exe-cuted at prices well below prevailing market levels earlier in the day. Professionals also suffered from the volatility: Liquidity providers who bought at distressed prices and hedged by short selling sim-ilar secu rities or fu tu res contracts incu rred steep losses as their long positions were canceled while the assets they had shorted rebounded in price.

It is difficult to overstate the potential negative consequences of another flash crash. Such an event cou ld dramatically erode investor confidence and participation in the capital markets for years to

come, leading to reduced liquidity and higher trans-action costs.1 A future flash crash toward the end of the day could severely disrupt the close and, hence,the pricing of index derivative produ cts, with follow-on effects for foreign markets and the subse-quent day’s open. Finally, the flash crash has already prompted several pu blic policy initiatives, and a repeat event could induce dramatic changes to mar-ket structure and the regulatory environment.

Given these concerns, a considerable effort has been made to understand and isolate the “cause” of the flash crash with a focus on the precise chronol-ogy of events. This article instead focu ses on the relationship between market structure and the flash crash withou t taking a view on its catalyst. My hypothesis is that equity market structure is a key determinant of the risk of extreme price changes.Today’s U.S. equity market structure is highly com-plex, with 12 for-profit exchanges (e.g., the NYSE)and some 30 odd dark pools competing for flow.Dark pools offer nondisplayed liqu idity and inclu de broker/dealer dark pools (e.g., Goldman Sachs’ Sigma X), exchange-owned pools (e.g., Direct Edge), and independent pools (e.g., ITG’s POSIT).

The resu lt of this proliferation of venu es is greater fragmentation of trading. Fragmentation u su ally refers to the actu al pattern of volu mes traded across different venues. In December 2011,based on trade-level data, the major market centers’share of total U.S. equ ity dollar volu me traded showed considerable dispersion, with NASDAQ at 23.8%, NYSE Arca at 16.5%, NYSE at 12.6%, BATS at 11.9%, Direct Edge EDGX at 8.1%, and the remainder accounted for by other exchanges and dark pools/broker internalization, included under FINRA’s Trade Reporting Facilities. Nor is this phe-nomenon limited to the United States or just equi-ties. In Europe, such entrants as Chi-X Global and

Ananth Madhavan is managing director at BlackRock,Inc., San Francisco.

Exchange Traded Funds Market Structure and the Flash Crash 5

Exchange Traded Funds Market Structure and the Flash Crash 5

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