Late last fall, on a crisp Friday morning in downtown Manhattan, 40 ETF trading and market structure experts from across the country converged around a giant boardroom table at the New York Stock Exchange. This was the seventh such roundtable held since August 24, 2015 — an unusual day marked by extreme dislocations at the start of trading hours. Last fall’s topic of discussion: market-wide circuit breakers.
Created after the October 1987 market crash and last updated in 2013, market-wide circuit breakers serve to halt trading across US securities in the event of a severe market drop that could exhaust liquidity. They start with a 15-minute “Level 1” halt in the case of a 7% one-day decline in the S&P 500 Index.
At the time of the 2019 meeting at the Exchange, the circuit breakers implemented in 2013 had never been triggered. The largest ETF issuers — including State Street Global Advisors — focused on two important questions:
- Were market makers, broker-dealers, and exchanges prepared to reopen the market smoothly if a halt happened?
- Were we confident that investors — from the smallest retail investors to the largest institutions in the world — could rely on ETFs to function as designed in such a scenario?
Providing effective service to our clients depended on getting these answers.
August 24: Past and present
Looking back to August 24, 2015, the two key measures intended to address extraordinary volatility — the market-wide circuit breaker procedures and the limit up-limit down (LULD) mechanism — ended up disrupting, rather than stabilizing, market operations.
First, market-wide circuit breakers, which could have helped stabilize markets, weren’t triggered, even though S&P 500 ETFs and futures fell through the 7% tripwire that should have been triggered by the protections. The automatic Level 1 safety measures did not kick in because the S&P 500 Index declined by only 5.2%. At the time, the index calculation used stale inputs for stocks that opened on a delayed basis because of the volatility.
Secondly, the events five years ago provided the first large-scale test of the LULD mechanism, which was introduced following the “flash crash” of May 2010. Limit up-limit down sets price bands around individual stocks and ETFs, preventing trades from happening at erroneous prices due to momentary gaps in liquidity. The mechanism incorporates single-security trading halts and reopening auctions to accommodate fundamental price changes in fast-moving markets. On August 24, 2015, the LULD mechanism disrupted the market’s functioning, leading to an extreme number of trading halts in individual securities. This obscured valuations, harming investor confidence.
Since 2015, members of the ETF liquidity ecosystem — including exchanges, market makers, broker-dealers, and issuers — have played a central role in addressing the problems exposed on that day. Collectively, we have worked to shore up investor confidence in the market’s functioning.
One important change that has taken place is that the S&P Dow Jones Indices now use consolidated data across all trading venues to calculate the S&P 500 Index — this ensures that delayed openings of certain stocks on their primary exchange won’t understate a market decline that could trigger a market-wide circuit breaker.
Additionally, several changes were made to the limit up-limit down mechanism to enhance the investor experience. For example, “Amendment 10” revised the reference price used to calculate the first LULD price bands of a trading day for securities that open on a quote (i.e., without opening auction volume). The previous day’s closing price is now used rather than the midpoint of displayed quotes at the open. This change resulted in an 80% decline in the number of LULD halts occurring on a daily basis.1
“Amendment 12” required that orders be consolidated in the reopening auction on a security’s primary listing exchange following an LULD halt. This prevents trades from occurring at erroneous prices before LULD price bands have been established — a phenomenon from August 24, 2015 known as “leaky bands.”
Finally, exchanges have harmonized their reopening auction procedures following LULD halts. The updated procedures provide for a gradual expansion of auction “collars” until a security can be reopened at a new price level, thus reducing the risk of additional LULD halts occurring immediately after a security reopens. Market makers have played a critical role in adopting these changes, providing price transparency when LULD halts occur across many securities.
ETFs pass the pandemic’s volatility test
In last fall’s boardroom convocation addressing additional refinements on behalf of investors, no one could have known that halfway around the world, COVID-19 was emerging and that it would result in a global pandemic that would wreak havoc on everything from human populations to national economies and international markets. Since then, the fallout from the virus has tested the US ETF ecosystem like never before, triggering four separate market-wide circuit breakers this year — on March 9, 12, 16, and 18.
During this volatility, the market plumbing has functioned flawlessly for all intents and purposes, thanks to ETF issuers, exchanges, market makers, and broker-dealers engaging and cooperating proactively over the past five years.
Limit up-limit down statistics reveal the stark contrast in the market’s functioning in 2020 compared with 2015. On March 9, 2020, there were 518 LULD halts, as compared with 1,278 on August 24, 2015. ETFs, which constituted 40% of US equity market notional volume on March 9, 2020, made up only 22% of the halts, in contrast to 83% of the halts on August 24, 2015.2
The ongoing vigilance by members of the ETF ecosystem has contributed to the resilience of equity market structure. That is why five years after August 24, 2015, though much has changed, the mission of our Capital Markets Group remains constant — promoting well-functioning markets in which investors can buy and sell ETFs with confidence.