Exchanges, Regulators Scramble to Fix ETFs After August Rout

(Bloomberg) — U.S. stock exchanges and regulators are scrambling to make exchange-traded funds less susceptible to disruptions after last months volatility triggered wild price swings for hundreds of the investment products.

The chief executive officer of Bats Global Markets Inc. said Thursday that rules governing U.S. markets need to be updated because they arent designed to cope with the proliferation of ETFs, instruments that typically track a broad investment portfolio but are bought and sold like individual stocks. An official at the New York Stock Exchange added that it has hired a consultant to review how ETFs trade on the companys markets.

When markets plunged Aug. 24, ETFs had the biggest issues, prompting questions from regulators, money managers and exchanges over why values diverged so widely from the individual stocks the investments are meant to follow. The price swings led to trading halts for more than 500 ETFs, raising concerns that the day was a preview of worse problems down the line as money continues to flow into the $2 trillion industry.

Markets Unprepared

The amount of capital shifting into that product is extraordinary and will continue, Bats CEO Chris Concannon said at a conference in Washington. We are not prepared for that. We have not built the systems. We have not built the market structure.

U.S. Securities and Exchange Commission officials are currently reviewing whether they should revise curbs on how much prices are permitted to rise or fall on a given trading day due to concerns that those protections dont work for ETFs, Commissioner Michael Piwowar said at the same Georgetown University conference where Concannon spoke. Even before last months disruptions, the SEC had asked exchanges to explain why trade halts are more common for ETFs than individual stocks, according to a person familiar with the matter.

One issue that stuck out Aug. 24 was that ETFs began trading that morning and subsequently plunged. Meanwhile, some of the underlying stocks that those ETFs are linked to hadnt even started trading yet.

BlackRock Inc. has talked to regulators about what happened and is working on a series of recommendations that could improve market structure, Chief Financial Officer Gary Shedlin said Thursday at a conference in New York. One of the biggest providers of ETFs, BlackRock wants investors to have confidence in the products even though events that the company cant control sometimes disrupt markets, he said.

We fundamentally believe that what we are dealing with is an equity market structure issue and not an ETF issue,” Shedlin said.

ETF Boom

Exchanges have benefited from ETFs, as listing and trading fees generated from them have spurred revenue growth. The New York Stock Exchange now lists over 1,500 exchange-traded investments, with 154 new ones started this year. The products are popular with investors, because they have lower fees than traditional mutual funds and its easier to add or pull money.

The NYSEs new consultant will review the mechanics of how ETF trading halts function, Stacey Cunningham, the exchanges chief operating officer, said at the conference in Washington. The effort will also try to assess whether brokers need better incentives to keep trading when markets turn choppy, she said.

Cunningham and Batss Concannon traded barbs last Thursday over how much of the trouble on August 24 stemmed from NYSE opening its trading late for some stocks. The NYSE invoked a rule that allows its brokers to open stocks manually, rather than displaying every electronic price quote they receive. Cunningham said the decision helped stabilize markets.

Concannon said the move allowed brokers to gouge investors. Some trades of private-equity firm KKR & Co. were executed at $8, down from an opening price of $17.73.

The specialist in KKR stole money from investors, Concannon said. He needs to give it back.