Because Black Monday happened so recently, there have been no firm rulings by the Securities and Exchange Commission (SEC) or the Commodity Futures Trading Commission (CFTC) yet. However, we can use the events and eventual regulations which came from a similar event in the markets, the Flash Crash of 2010, to guess at what is coming next. First, let’s break down the two events.

What it Was:

On August 24 of this year, “Black Monday,” ETFs experienced dramatic price swings and an unusually high number of trading halts during the first hour of trading. The Dow Jones Industrial Average fell by 1,000 points on fears of China’s economic slowdown.

Why it Happened:

ETFs are composed of two layers, which include shares that trade like stocks as well as the basket of underlying securities that the ETF represents. If a stock trading in an ETF’s basket is halted, then the ETF becomes impossible to price in real time. The inability to price the ETF in real time on Black Monday caused liquidity providers of the ETFs to take a step back and stop providing liquidity.

The lack of liquidity caused traders who were selling their shares into the market to receive prices that were well below “fair value” for the ETF, sometimes as low as one penny per share. These losses could have been avoided had the sellers issued “limit sell” orders instead of “market sell” orders.

What it Was:

On the afternoon of May 6, 2010, American stocks and futures fell by 10% in a matter of minutes, with some blue-chip stocks trading for pennies. Most of these assets recovered their lost ground throughout the day, but the quick drop raised many hard questions about whether trading rules had kept up with high-speed trading.

Why it Happened:

According to a joint report by the SEC and the CFTC, the crash was triggered by a large sell order in “e-mini” futures. When this order was placed the trading environment was experiencing high volatility and thin liquidity due to unsettling economic and political news. Because the trading algorithm was programed to take volume into account, the order was executed rather quickly.

Initially, high-frequency traders absorbed the sell order of “e-mini” futures, but ten minutes later those traders began selling to reduce their “long” positions. The quick liquidation of these shares into the market created a duel liquidity crisis, one at the broad index level and one at the individual shares level.

At the broad index level, algorithms played a trading game of “hot potato” as volume increased, but there was little net buying.

As this was going on in the broad markets, automated trading systems by traditional market makers in individual securities paused. These systems paused due to the unusual activity in the broad markets, waiting for human traders to step in and assess the risks hands-on. The traders feared that a cataclysmic event was occurring in the markets that they did not currently understand and so widened their spreads significantly or left their market-making trading systems offline.

These events caused liquidity to dry up in the market which in turn caused share prices to plummet as there were no buyers to match with sell orders.

The SEC and CFTC created a series of new trading rules to deal with the market flaws that were exposed during the Flash Crash of 2010. Check out the below links for the details of those rulings.

• SEC Final Rule: Risk Management Controls for Brokers or Dealers with Market Access
• SEC Final Rule: Consolidated Audit Trail
• CFTC Final Rule: Customer Clearing Documentation, Timing and Acceptance for Clearing, and Clearing Member Risk Management
• CFTC Final Rule: Interpretive Guidance: Disruptive Trading Practices

The objective of these rules is to ensure that clearing mechanisms are more thoroughly tested before they are used in the open market. Also, these rules ensure that audit trails will be clear and unrealistic trades will not be filled. Hopefully with the addition of these rules, there will never be another flash crash again.

Much like their response to the Flash Crash of 2010, the SEC is proposing that ETFs formally determine how they manage liquidity, or the ability to buy and sell assets, with the fund boards.

Considering the regulations that came the Flash Crash, the rules that the SEC eventually decide on will likely include more rigorous stress testing for ETFs as well as increased audit trails. These rules will make ETFs safer for investors as they should reduce the chances of such crises happening again.

Image courtesy of Vichaya Kiatying-Angsulee at FreeDigitalPhotos.net