Nasdaq has published the list of trades it cancelled as a result of Thursday’s epic market ‘flash-crash’ — and as it transpires, a significant number of those affected were ETFs or ETNs.
Index Universe sums up the situation — although remains baffled as to why.
While we at FT Alphaville can’t definitively explain the reason either, we can point to a few market-structure factors that could offer some clues.
1. ETF and ETN trading is closely related to high-frequency trading.
Constant market-making and arbitrage opportunities are provided to authorised participants (often high frequency trading firms) by the ETF model’s dependence on converging to the net asset value on a daily basis. A typical fund has about five authorised participants.
The so-called creation and redemption mechanism allows authorised participants to lock-in profits when the shares of ETFs over-price or under-price the NAV, since only they are allowed to redeem or create shares at the official NAV price of the funds.
The arbitrage opportunity model exists to make sure that ETF share-prices always end up tracking their underlying indices.
Many high frequency and algorithmic strategies have been fueled by the need of market makers and APs to spot and trade index arbitrage opportunities arising from this situation ever more efficiently. The profits are often tiny, hence the need to act quickly and frequently.
2. Market maker hedging.
Since APs only get to create or redeem once a day at the NAV, they usually hedge their exposure through purchasing or shorting underlying stocks.
In some cases, the create-to-lend mechanism allows such dealers to sell ETF stock which they don’t own yet — in exchange for a basket of underlying constituent shares. They then later switch this basket for fresh shares from the issuer.
Dynamic hedging is needed to protect the arbitrage until the moment the creation or redemption process can take place.
A significant change in any constituent stock in the interim can can hence fuel frantic fine-tuning of positions ahead of NAV publication time.
3. Counterparty risk.
ETF collateral isn’t always what it seems.
Traditional replicated funds, which hold constituent underlying stocks to achieve tracking, can lend out stock. From the point of view of the investor, this can expose them to counterparty risk.
Meanwhile, from the point of view of the market maker, this can blur the true indicative net asset value of the fund.
Any suspected counteparty issue at a fund could be enough to spook APs and market makers from providing liquidity across the board, while they reassess their exposure.
Since there’s only a handful of key names operating as APs — who happen, via their hedging needs, to provide a great deal of the volume in ordinary trade on exchanges too — it doesn’t take much to see the contagion spread quickly across the market.
4. Unexpected correlations.
In some swap-based models, it’s even more the case that ETF collateral is not what it seems. Some funds in Europe, for example, are particularly partial to hedging European and US equity funds with Japanese equities.
With ETNs, meanwhile, it’s never clear how the actual issuer is really hedging his exposure, since the security is a bond backed only by the full faith and credit of the issuer.
An extreme move in a completely unconnected security might hence prompt a daisy chain reaction back to US equity ETFs.
Note, for example, the move in the yen on Thursday (H/T Sean Corrigan):
All thoughts welcomed.
Related links:
Vertical vertigo in ETFs - FT Alphaville
Deutsche Bank the flow rider - FT Alphaville
Was 2009 the year of the market maker? - FT Alphaville