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4 ETF Lessons From Knight

Dave Nadig


After Knight lost a tremendous amount of money , it looked like it had stepped away from the ETF markets, and we published a back-of-the-envelope spot-check on how that might have effected ETF spreads . In that piece, I looked at noon spreads for the two days prior to last Wednesday, when Knight’s algorithms ran amok, and compared that with Wednesday’s and Thursday’s spreads. I commented at the time that my analysis was extremely quick-and-dirty, looking at just one spread point a day, and assuming it was representative.

We spent the weekend buffing that out, grinding through the actual moment-by-moment spreads on all of the NYSE ETFs for which there are lead market makers (about 1,000) over all of the last week. The results, unsurprisingly, broadly match up with our original findings. The spreads on less liquid ETFs (those trading fewer than 50,000 shares a day, on average) widened out in the wake of Knight’s issues.

Quoted Spreads on ETFs w/ NYSE LMMs

We’ve done a few additional things here that are worth pointing out. First, based on this analysis, spreads on Knight LMM ETFs that already had low liquidity broadened out from 50 to 144 basis points during the crisis. However, by Friday, those spreads pulled way back in to 89 bps. From our analysis, this was not because Knight all of a sudden started making good markets.

Even this morning, a spot-check of the less liquid ETFs showed Knight still very far outside the current bids and offers. Instead, what we’ve seen is that other market participants—both market makers and regular traders—have noticed the spreads on these small-but-still-trading securities and have jumped at the chance to be the guy offering just slightly better prices than we saw before.

In the most liquid ETFs, the situation is generally unchanged. That’s to be expected, since they were essentially unaffected by all this kerfuffle in the first place.

So with things getting back to normal, I thought I’d address a few “lessons learned” from this experience.



1. Lead Market Makers matter. The LMM system at the NYSE has been accused of essentially having no teeth in the past. The LMM for an ETF makes a commitment to provide liquidity by being on the inside of the bid/ask spread—effectively, paying attention to the security throughout the trading day. They’re measured (theoretically) by the exchange to make sure that for some reasonable portion of the time, they actually “are” making the best market. For this, they get payments from the exchange for helping keep trading flowing—a rebate per share.

It turns out, having an LMM paying attention matters. At least, it certainly mattered if Knight was your LMM and they stepped to the sidelines like they did last Wednesday. The market-making system is far from perfect, and I’m still on the fence about proposals to make flat, nonflow-based payments to firms that show up for LMM on the first day a fund trades. But there’s no question that having someone paying attention to your small ETF matters.

NYSE seems to get this. As of this morning, NYSE has removed Knight’s LMM status on hundreds of stocks and ETFs, temporarily  reassigning those tasks to Getco .

2. Markets Work. I don’t mean this in any kind of Pollyanna-capitalism, uber-alles sense. What I mean is that the astounding thing about Knight’s enormous software boo-boo is how well the market did exactly what it’s supposed to do. Thousands of market participants quietly took the other side of all of these misplaced Knight trades, right until Knight hit the “off” switch. Then all those stocks just settled right back down. The end result of course was hundreds of millions of dollars being transferred out of Knight and into the hands of other traders.

That’s exactly how the market is supposed to handle people who make bad calls. It’s supposed to take their money in a calm and orderly way. It makes me extremely sad for the folks at a firm like Knight that end up suffering for the mistakes of the few folks likely responsible, but it’s also an example of exactly what’s supposed to happen. They ain’t perfect, but markets work.

3. Settlement Works. I got a lot of panicked calls from reporters over the last week asking what would happen to all of the trades Knight had made if they should spontaneously combust. It was a fair question, because at some points last week, the rumor mill was suggesting we might indeed have a midday bankruptcy. The basic premise of all these questions was, “Well, if you bought 1,000 shares of CRUD yesterday from Knight, what happens when Knight doesn’t exist tomorrow and those shares haven’t yet settled?”

The answer, of course, is you still get your shares. Any trade that gets confirmed at the end of the day by the NSCC goes into what’s called their continuous net settlement process (CNS). A cornerstone of CNS is that once the trade is in the system, Knight is no longer your counterparty—the NSCC is. And the NSCC has enormous cash reserves (contributed by members like Knight) that it controls precisely to handle things like the default of other members. So if Knight had sold you 1,000 shares of CRUD, went bankrupt, and turned out not to have 1,000 shares of CRUD on inventory at the NSCC, then the NSCC would have taken some of Knight’s cash—or at worse, some of its own reserves—and bought your CRUD for you to make sure your trade settled.

We know this works, because we’ve seen it happen before. Even before the NSCC changed the rules to become the counterparty for all trades on submission , it successfully dealt with both Lehman and Madoff without having a penny of settlement failure. (Under the current system, that confirm slip in your email box is effectively ironclad.)

4. Illiquid ETFs Need Helpers . Not everyone was particularly happy I pointed out the wide spreads on less liquid ETFs last week. They’ll probably be unhappy I’m reiterating those spreads with the minute-by-minute analysis today. But the point remains that ETFs that only trade a handful of shares a day are enormously challenging for small investors.

But there’s a catch. Even the least liquid ETFs—something like the iShares MSCI ACWI ex US Information Technology Sector Index Fund (AXIT) can actually still be traded reasonably well. That might seem ludicrous when you look at the numbers. The fund trades less than 100 shares on an average day, and is consistently quoted at spreads of 2-3 percent. Can you get a fair deal by posting a trade for 5,000 shares in your Schwab account? Probably not. However, if you wanted to trade, say 50,000 shares, chances are you could make that trade for a handful of basis points off of fair value, just by working that trade through a liquidity provider like Wallach Beth; a market maker like Susquehanna; or a trading desk at a firm like ConvergEx.

It’s not all roses—in our IndexUniverse ETF Analytics system , AXIT rightly scores just a 22 out of 100 for tradability. But even there, it’s possible. For most investors, however, illiquid ETFs remain a place where professional help is going to be the norm, not the exception.

It’s All Good

In general, all four of these lessons are good news. There’s a system here. Far from an investor-shaking flash crash, last week turns out to be a testament to just how well that system works.

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