How Can the Markets Best Adapt to the Rapid Growth of ETFs
Commissioner Luis A. Aguilar
Oct. 15, 2015
Thank you and good morning. I want to extend a warm welcome to the members of the Investor Advisory Committee (“IAC”). I look forward to your discussions today. I appreciate the important work that you do and, in turn, how this work facilitates the SEC’s efforts to fulfill its core mission. I also want to welcome the audience, whether you are participating in person or remotely.
Let me start off by saying a few words about one of the members of this Committee who recently stepped down from his duties, Eugene Duffy. Many of you know Mr. Duffy for his wealth of experience as a knowledgeable executive and business leader in the real estate and asset management industry. You may also know Mr. Duffy’s prior public service as Deputy Chief Administrative Officer for the City of Atlanta, and as a top aide to former Congressman, U.N. Ambassador and Atlanta Mayor Andrew Young. What some of you may not know is Mr. Duffy’s longstanding dedicated efforts to advancing minority causes, including serving as the former Chairman of the National Association of Securities Professionals (NASP) and Chairman of the Board of Trustees for the National Association for the Advancement of Colored People (NAACP). Mr. Duffy also serves on the Board of Visitors for Emory University and the Atlanta Botanical Garden. Eugene is a self-less individual with an unerring focus on the needs of others. You don’t often run into such individuals and I’m glad to call him a friend.
Also, I would like to welcome to the Committee its newest members, Bill Lee, Matthew Furman, and Professor Lisa Fairfax. You all have extremely impressive resumes, and I am sure you will bring unique and valuable perspectives to add to this Committee. I look forward to your contributions to this Committee in furtherance of America’s investors.
Now, let me turn to today’s meeting. Today, the IAC’s agenda includes several topics important to investors. There are two particular agenda items that I would like to highlight. First, I am pleased that the Committee will be discussing recent market structure developments. I recently discussed this topic at length in a May 2015 statement on the structure of the U.S. equity markets, which some would describe as a tome at 12 pages and 184 footnotes. I understand that my prior statement is having an impact on on-going market structure discussions and I stand by its observations and suggestions.
With respect to a second item on the IAC’s agenda, the pricing of Exchange Traded Funds (ETFs), this is a complex matter that is ripe for discussion. As you know, on August 24, 2015, shortly after the opening bell, dozens of equity ETFs had their prices plunge far below the values of the indices they were designed to track. By one estimate, trading in ETFs was halted more than 1,000 times that morning pursuant to the limit up/limit down rules implemented in the wake of the 2010 flash crash, and this accounted for approximately 85 percent of all trade halts that day. Why ETFs proved so fragile that morning raises many questions, and suggests that it may be time to reexamine the entire ETF ecosystem. Some questions that I hope this Committee explores as part of its work include the following:
- Should trading in ETFs be halted whenever a significant number of their portfolio assets are subject to a trading halt? If so, what would be the appropriate threshold to trigger such a halt in trading? Or would it be better to allow ETFs to continue to trade under those circumstances so that trading in ETF shares could potentially drive price discovery for their underlying assets?
- Do the limit up/limit down rules need to be revised so the arbitrage mechanism ETFs use can function during periods of acute volatility, without triggering an excessive number of trade halts? For example, should ETFs have their own price bands that differ from those for individual stocks? And should the price bands be narrowed at the start and the end of the trading day, since volatility is likely to be highest during those periods? Or would it be preferable to base trading halts on some metric other than a price band? For example, could the trigger be based on the extent of the imbalance between buy and sell orders in the market?
- Should the market-wide circuit breakers be recalibrated to help markets better deal with broad-based events? Should we consider establishing circuit breakers that are based on the number of securities that have been halted, rather than the severity of price movements?
- Does potential uncertainty about when trades will be broken inhibit the efficient pricing of ETFs, for example, by threatening the ability of liquidity providers to hedge their positions? Similarly, under current thresholds, there are many situations in which a trade could be declared erroneous even though it falls within the limit up/limit down price bands. Does this foster confusion that could hinder liquidity provision and arbitrage activity for ETFs during periods of market stress? Should the limit up/limit down price bands be harmonized with the erroneous trade guidelines?
- How can we better ensure transparency and timeliness at the open of the primary listing markets? What role should manual procedures play, such as those used by the New York Stock Exchange? Could manual procedures unnecessarily delay the opening when broad-based market events occur? Should the New York Stock Exchange consider publishing its Order Imbalances data feed even after the market opens when the openings for some stocks are delayed, as they were on August 24th?
- How can liquidity providers for ETFs be better incentivized to participate during periods of extreme volatility? Would providing ETF market makers a limited exemption from the short sale price test restrictions of Reg SHO help make ETF pricing more accurate?
- How has the growth of ETFs and their proliferation into less liquid asset classes challenged the effectiveness of the ETF arbitrage and pricing mechanisms? Are sophisticated traders able to exploit inefficiencies in the pricing mechanisms of less liquid ETFs to the detriment of retail investors? Should we consider permitting alternative pricing methods for less-liquid ETFs, such as so-called NAV-based trading, where ETFs trade based on a specified premium or discount to the ETF’s net asset value? Should we consider potentially curtailing the growth of ETFs?
The IAC’s views on these and other questions can prove immensely valuable to the Commission. It seems fairly certain that the explosive growth of ETFs in recent years poses a challenge that isn’t going away — and may well become even more acute as new ETFs enter the market.
I conclude by thanking the IAC for its work. Your efforts help to protect investors and preserve the integrity of the capital markets.
 See Commissioner Luis A. Aguilar, U.S. Securities and Exchange Commission, U.S. Equity Market Structure: Making Our Markets Work Better for Investors (May 11, 2015), available at http://www.sec.gov/news/statement/us-equity-market-structure.html.
 See Chris Dieterich, Many ETFs Saw Wacky Trading In Monday’s Selloff, Barron’s (Aug. 25, 2015), available at http://blogs.barrons.com/focusonfunds/2015/08/25/many-etfs-saw-wacky-trading-in-mondays-selloff/#.
 Comment Letter to Request for Comment Regarding Exchange-Traded Products, 5 (Sept. 5, 2015) (noting that “[o]f the 1,237 individual circuit breaker trading halts in U.S. traded securities on August 24th, 1,046 were [exchange traded products] or 85%”), available at https://www.sec.gov/comments/s7-11-15/s71115-38.pdf.
 Exchange Act Release No. 75165, Request for Comment on Exchange-Traded Products, 3-4 (June 12, 2015) (noting that the total number of exchange traded products rose by an average of 160 per year between 2006 and 2013, as compared to an average growth of just 17 per year from 1993 t o2005), available at http://www.sec.gov/rules/other/2015/34-75165.pdf. Last year alone witnessed the advent of 205 new ETFs. See Tom Lydon, New ETFs: Too Much too Soon?, ETF Trends (Aug. 3, 2015), available at http://www.etftrends.com/2015/08/new-etfs-too-much-too-soon/.