Deeper Dive into How Tighter ETF LULD Bands Would Work

We recently looked at the LULD rules and found that exchange-traded funds (ETFs) triggered just a fraction of all LULDs over the past two years. This is partly due to the diversification benefits of ETFs, which represent a portfolio of underlying stocks. We showed that the volatility of ETF tickers was usually a fraction of the volatility of any of the underlying stocks.

We then compared the ETFs in Tier 1 and Tier 2, and we see that:

• Volatility is virtually identical (Chart 1, left). The typical whole-day ranges of prices for most tickers in both groups are under 2%
• Liquidity is lower in Tier 2 ETFs. That’s by definition since liquidity is how ETFs are allocated to the tier.
• Spreads in some Tier 2 ETFs are wider, but despite the lower liquidity, the majority of Tier 2 spreads are less than 50 basis points, which is still a fraction of the smaller Tier 1 band (Chart 1, right), meaning a tighter band shouldn’t be triggered by wide spreads.

It made us wonder, would it make sense for Tier 2 ETFs to be combined with Tier 1 ETFs?

Chart 1: Tier 1 and 2 ETFs have almost the same volatility and spreads that are well inside Tier 1 bands

What would happen if LULD ETF groups were merged?

Right now, Tier 2 ETFs have bands that are twice as wide as Tier 1 ETFs (10% instead of 5%) for most of the day. Although after 3:35 p.m., Tier 1 stocks switch to “double-wide” bands, which means Tier 1 & 2 stocks already have identical width bands at the end of the day.

Because we are modeling tighter LULD bands, we are able to use real trading to see how often the actual Tier 2 ETFs would have hit Tier 1 bands. Our analysis looked at all dates in 2020 and 2021 (except MWCB days). The results suggest putting Tier 2 ETFs into Tier 1 would increase their LULD halts by ten-fold, from just 56 to 565 last year. 

Chart 2: Putting Tier 2 ETFs in Tier 1 would significantly increase LULD halts (excluding MWCB days)

Although that might seem like a lot, it adds to less than two per day in 2021. It also results in Tier 2 ETFs (with Tier 1 bands) having a similar likelihood of a halt as a Tier 2 stock (with Tier 1 bands).

Why is the increase in LULDs so large?

Given Tier 2 ETFs weren’t any more volatile than Tier 1 ETFs, we wanted to understand how the LULD halts increased so much. 

It turns out the answer is in the LULD math. Remember that LULD bands are based on average trade prices in the prior 5 minutes. For tier 2 ETFs, it turns out that’s very important because Tier 2 ETFs are the stocks with lower liquidity, and without any trades, LULD bands don’t update. 

Instead, what happens to many Tier 2 ETFs can be seen by the example in Chart 3 below, which plots the De-SPAC ETF (Nasdaq: DSPC). Note that DSPC is the first ETF to offer a portfolio exposure to completed SPACs, so it has only U.S.-listed stocks in its portfolio, which are trading at the exact same time as the ETF. That means market makers can calculate an accurate “real-time” NAV, allowing them to quote with tight spreads and frequent price updates (which we see in Chart 3 from the green lines moving a lot but remaining very close together):

• The light and dark green lines show the bid and offer. The fact they are touching shows the spread is very tight. The fact that they are moving shows market-maker prices update to match NAV very frequently. 
• But there are no yellow dots (no round lot trades) until the end of the day.
• This lack of trades also means there were not even any arbitrage opportunities. So, the NAV of the ETF rose consistently during the day, from around $21 the night before to almost $22.50 in close.
• However, the LULD bands did not update (dark blue represents the current Tier 2 bands calculated by the SIP).
• As a result of the bid rising during the day, the quotes eventually hit our “virtual Tier 1 LULD” (light blue lines), which would have caused a limit-up halt around 1 p.m. under our proposed new regime (red quotes).

Chart 3: Modeling how half bands work for Tier 2 stocks

Importantly though, the additional LULD halt auction helps reset the bands by: 

1. Reopening a trade will reset the LULD Reference Price to the trade price.
2. If there is no trade and the LULD halt auction reopening, the LULD Reference Price is based on the midpoint of the Primary Listing Exchange’s quote.
3. In the uncommon event of a LULD halt auction with neither a trade nor a two-sided quote, the LULD Reference Price will reset the Price Band that was in a Limit State before the Trading Pause (the red prices in Chart 3).

Ironically, given some of these ETFs are less liquid and have wide spreads, and may NOT be able to calculate a live NAV (like we can for DSPC), the third option above might actually work better than the second choice (using midpoint) even in an Auction with no trade.

In fact, the LULD plan already modified its rules to not use “quote midpoints” in the official open because it sometimes set bands away from fair market levels, resulting in more LULDs when the first actual trade occurred.

Most of the new LULD halts aren’t bad at all

Although halting trading more often sounds bad, as it limits liquidity to investors, our analysis shows that it actually affects very little trading and would actually affect very few investors.

In fact, the data shows that during more than 91% of the additional “virtual” halts, no trades happened at all. Those halts where trades did actually occur added to just 0.035% of all Tier 2 liquidity, which, remember, only includes the less liquid ETFs.

Our results also suggest that half (49%) of these additional halts occur in the first 15 minutes of the day, as NAV calculations and ETF quotes update for overnight .

Chart 4: Even with more halts, very little trading would be affected

 

So, it seems the impact on liquidity and investors would be minimal.

But more importantly, by resetting the LULD bands to tighter Tier 1 bands for all ETFs, the guardrails should stop more trades that are far from fair market valuation of the ETFs from occurring, which is good for investors.

What does this really mean?

ETFs are both stocks and portfolios of stocks. Because of that, ETF liquidity doesn’t necessarily mean the ETFs will be more volatile or harder to trade in size.

LULD bands create guardrails that protect investors from bad trades and runaway markets. It follows that investors might have better protections if all ETFs were using Tier 1 bands. 

However, we estimate that putting all ETFs into Tier 1 would trigger around 10-times as many LULDs as we see now. It turns out that’s because Tier 2 ETFs are often thinly traded, and without trades, LULD bands can become stale.

However, because Tier 2 ETFs are often thinly traded, these additional halts would affect very little trading. Instead, the additional halt represents an opportunity to reset the band close to market prices. And that, overall, should be good for investors.

Phil Mackintosh

Nasdaq

Phil Mackintosh is Chief Economist and a Senior Vice President at Nasdaq. His team is responsible for a variety of projects and initiatives in the U.S. and Europe to improve market structure, encourage capital formation and enhance trading efficiency. 

Read Phil's Bio