Reggie Browne, perhaps the most influential ETF trading
expert in the world, says investors are clearly starting to grasp
the power of the ETF, but they are still assimilating all the
nuances of ETF trade. That knowledge gap is more significant than
meets the eye, as ETF trading these days can amount to as much as
40 percent of dollar-value trading volume on U.S. exchanges.
Moreover, as the financial world began to grasp three years
ago when the "flash crash" whipsawed markets in a dramatic
30-minute period before the close,
may trade in real time like stocks, but they're different in
important ways. On that day, after all, about two-thirds of all
the securities with canceled trades were ETFs. That fact led
regulators to get to work.
Browne, who declined to discuss the acquisition of his firm
Knight Capital by high-frequency trading firm Getco, did tell
IndexUniverse.com Managing Editor Olly Ludwig he believes that it
would be foolhardy to say that another flash crash can't happen.
But he detailed some of the encouraging steps regulators have
taken to ensure that the world of electronic trade remains stable
even as it delivers the tight spreads and lower costs investors
should be happy about.
Are investors and advisors getting wiser to trading ETFs
correctly? What is your biggest recommendation to them to get it
The industry is doing a good job educating investors, advisors and
the media about how ETFs are structured while dispelling the
considerable misinformation that some people have. Investors are
increasingly coming to appreciate that ETFs offer greater
transparency than mutual funds, with the added advantage they can
be easily traded in real time.
But ETF execution is still not yet widely understood. Take the
example of a request to trade $75 million of a midcap ETF such as
the MDY (NYSEArca:MDY) within 2 cents of the bid or ask. That
narrow a spread is possible with a large-cap ETF such as SPY
(NYSEArca:SPY) with an exceedingly large secondary market volume,
but such a spread is probably not realistic for a midcap ETF given
the underlying liquidity of the stocks, related futures and
notional value of the trade.
Investors need to understand that when they choose an ETF for
asset class exposure, they need to be cognizant of the fundamental
liquidity of the underlying basket and the impact of trade
IU.com:A lot of people talk about limit orders being the
way to go to get the right execution. Is that your opinion
Limit orders are appropriate for individual investors who execute
through the trading desks of retail brokerage firms. Larger orders
generally require the expertise of a professional trading desk.
Institutional investors and wealth managers with large orders can
contact trading desks and market makers directly and determine
alternative options to the displayed screen price.
The size of a trade can actually have an impact when you are
trading ETFs in certain asset classes. Sometimes it can be more
advantageous to simply have a trading desk create new ETFs rather
than purchasing the ETF on the open market. Some ETF sponsors have
the NAV of an ETF fund plus a preset spread, which is available
only on creation-unit-sized orders. Limit orders may imply there is
sufficient liquidity in the secondary market for the order to be
IU.com:What's the downside to a limit order that some may
Limit order use requires that the investor monitor the order and
the market for an execution. Markets are constantly moving, so
refreshing or readjusting the limit may be required in order to
receive an execution. There is little downside if the investor is
attentive to the market. However, investors should note, in a
volatile market they may miss the opportunity to trade at their
intended price or they may end up paying a price compared to
IU.com:Do you buy that electronic, algorithmic markets
are creating instability?
Since the electronic formats are still relatively new, the industry
and regulators are still in the process of identifying risks and
quickly addressing them with new regulations. With the adoption of
Regulation NMS [Reg NMS], regulators have created exactly what they
intended:a faster, easily accessible and more transparent market.
This, in turn, has lowered trading costs and has been a major boon
IU.com:Is the "flash crash" of May 6, 2010, history, or
could it happen again?
One would never be so bold as to predict that a flash crash could
never happen again. Technology allows for great efficiencies and
market improvements, but it would be dangerous to assume that the
recent enhanced regulation in response to the flash crash can
prevent another such event.
That said, regulators have taken some important measures to help
prevent another such event. The most notable is the new limit
up/down rule which acts as a circuit breaker for equities. The new
limit-up/limit-down rule is designed to limit the short-term price
volatility of a single security, and replaces the single-stock
circuit breakers. Limit-up/limit-down price bands for each security
will be set-and reset throughout the trading day-at a percentage
above and below the security's average price over the prior five
minutes of trading. But it will not be reset if price movements
within the period are 1 percent or less.
The price band for most stocks in the S&P 500 Index and the
Russell 1000 Index, as well as certain exchange-traded funds and
notes [Tier 1 NMS securities] is 5 percent. The price band for most
other listed stocks and certain other exchange-traded instruments
[Tier 2 NMS securities] will be 10 percent. Price bands will be
doubled during opening and closing periods, and broader price bands
will apply at all times for listed stocks and exchange-traded
instruments priced at or below $3.00. If bid or offer
quotations are at the far limit of the price band for more than 15
seconds, trading in that security will be subject to a five-minute
Additionally, enhancements to the marketwide halt rules are
expected to further refine the situations where marketwide halts
occur that are tied to a broader index of securities rather than
just the Dow 30.
IU.com:What do you make of the exchange proposals that
create incentives for market makers?
Knight was an early proponent of this concept, and we believe that
the program will serve a great benefit to the marketplace in the
form of narrower spreads and increased liquidity.
Market makers and authorized participants are a key link in the
delivery chain to the market of new ETFs. Knight commits a
significant amount of capital to seed newly launched ETFs.
Unfortunately, the number of well-capitalized, committed seeding
market makers is shrinking, given the enhanced regulatory
Knight has emerged as leading market maker on nearly 35 percent
of ETF listings on NYSE Arca. We are one of the few remaining firms
still willing to commit capital to seed ETFs.
Well-established ETF issuers generally do not have problems
getting their new ETFs seeded, but the upstart firms do. The number
of new issuers at the various stages of entry seems to be growing
by the day. But seed capital and market-maker support without
enhancements to the ETF market structure will diminish given the
abundance of growing demand with a limited field of participants on
the sell side.
So, incentive proposals that strengthen market structure and
inherently entice market makers to assume a higher degree of
affirmative obligation merit backing from all participants. A large
and competitive field of market makers is needed to foster
innovation in the industry.
The incentive programs are intended to address not only seed
capital and the IPO process, but thinly traded ETFs that only have
one or two market makers quoting at the arbitrage bands or at the
underlying basket. Successful ETFs generally have two stages of
liquidity, retail orders inside the arbitrage bands; and
professional liquidity providers at various degrees through the
Thinly traded ETFs generally don't have the benefit of a deep
depth of book which is displayed, meaning it would be difficult to
determine where you can trade $200 million of a thinly traded ETF.
Our current market structure has created a vacuum in liquidity
discovery. The proposed incentive programs target this issue.
IU.com:Is there any place in modern markets for
old-school market makers who plied their trade on trading
Machines can do things very fast and very efficiently, but they are
limited when it comes to handling certain situations such as
illiquidity or unusual market conditions. We believe that a hybrid
approach is the best approach to deal with the situations that
automation cannot handle.
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