August 24, 2015 will certainly go down in the annals of market history. Extremely poor data and unprecedented activity in the Chinese economy/markets spilled over across the globe and hit the U.S. markets especially hard. The Dow Jones Industrial Average fell 586 points, or 3.56%. Likewise, the S&P tanked at 3.9% and the NASDAQ lost 3.82%, with both indexes ending at ten-month lows. At one point, the venerable Dow was down over 1,000 points.

The now-dubbed “Black Monday” also had implications besides the plunge in investors’ net worth.

All of this market mayhem and volatility caused rules designed to keep trading running smoothly to fail. More than 1,000 ETFs were halted as their prices swung so heavily away from their underlying net asset values (NAVs.) That widespread halt, as well as numerous canceled trades, has been met with some pretty hefty skepticism from regulators.

And now, it’s been met with some newly proposed rules governing ETFs.

As the number of ETFs has swelled over the last few years – currently numbering more than 1,700 – the stock exchanges have had to deal with that growth firsthand. According to the Securities & Exchange Commission (SEC), the exchanges may not be doing good enough jobs.

When things are going great, that’s wonderful, and most of the biggest and most liquid ETFs trade basically at NAV. When things get crazy – as they did on August 24 or back in 2010’s Flash Crash – that relationship can break down and completely eschew the NAV/ETF price relationship.

The real concern is that if bread-n-butter indexes can have major issues under supreme market duress, what will happen to the more complex products hitting the markets these days? Fund sponsors have jumped head over feet into using derivatives, swaps and other complex illiquid financial instruments in ETFs. This will pose a huge problem if there are issues with market-making, trading halts and other liquidity issues.

Which is why the SEC is taking a serious look at ETFs now.

SEC Chairwoman Mary Jo White reported that the investment agency is using data from Black Monday to examine ETFs. More specifically, the agency is looking into the operation of the limit up/limit down mechanism and the quality of ETP pricing in secondary markets. Some ETF sector watchers have proposed that the SEC might slow down the approval process for new funds – especially those that are complex in nature. The agency did not deny proposals but is providing reasons why they might be denying new ETFs in the wake of the trading scandal. The SEC hasn’t officially created new rules with regards to ETF trading yet.

However, in September, the agency did propose a new set of compliance rules for ETFs with regards to liquidity. And they are a doozy.

The basic gist of the 414-page document is to make sure that in case of a market panic when investors want their money back, ETFs will be able to do just that. Under the guise of the rules, ETFs will be required to estimate how long it would take to liquidate each of their holdings completely. A fund would be limited to only holding 15% of its assets in securities that would take seven days or longer to sell off. Another rule to note is the three-day liquid asset minimum the SEC is proposing. Under this new rule, a fund would be required to determine a certain percentage of liquid assets that can be converted to cash within three business days without affecting the market price significantly.

The rules, which are currently in the comments stage, would certainly have wide-reaching implications and potential repercussions across the ETF industry. Those implications could include larger ETFs potentially closing or splitting into multiple ETFs that are the same, as their huge position sizes make it difficult to “dump” assets in the seven-day time frame. Additionally, ETFs that track illiquid assets like junk bonds or bank loans could close completely as well as they can no longer meet the eligibility requirements. All in all, the rules have the potential to upend the ETF industry.

Black Monday certainly threw the ETF industry for a loop. The volatility wreaked havoc on the pricing mechanisms that ETFs need to thrive. With that in mind, the SEC has become a bigger watchdog with regards to the fund structure. The beginning steps of that is the agency’s new liquidity rules suggestions. While it remains to be seen if those proposals actually get enacted fully, as written, they could change the sector as we know it.

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