May 20, 2010 / 9:41 PM / in 8 years

U.S. ETF market would welcome circuit breakers

* Initial market protections do not apply to ETFs

* ETF participants say would welcome circuit breakers

By Aaron Pressman

BOSTON, May 20 (Reuters) - Participants in the $800 billion U.S. exchange-traded fund industry said on Thursday they would welcome a move to extend circuit breakers to their market as soon as possible.

The ETF market was hit harder than ordinary stocks by the May 6 “flash crash” but so far has been left out of potential market fixes.

“ETFs performed like other stocks that found no bids on the electronic exchanges,” said Thomas Dorsey, president of ETF research and money management firm Dorsey Wright & Associates in Richmond, Virginia. “Circuit breakers should help.”

“Circuit breakers make sense and we believe there is a need for them with both stocks and ETFs,” added Noel Archard, managing director at BlackRock’s (BLK.N) iShares unit, the largest manager of U.S. ETFs.

Even though the vast majority of stocks dropped 10 percent or less in price on May 6, many ETFs that track indexes of those stocks briefly lost more than 60 percent of their value, with a few even trading as low as a penny. More than two-thirds of the trades canceled from the wild 20-minute market maelstrom involved ETFs.

Securities regulators have proposed new trading curbs for the largest-capitalization individual stocks to go into effect in a few weeks. The new circuit breakers, which pause trading if a share price moves more than 10 percent within 5 minutes, will apply only to stocks in the Standard & Poor’s 500 Index under the initial pilot program expected to last until December.

The Securities and Exchange Commission said it plans to extend the trading curbs to ETFs and other stocks “as soon as practicable.”

The funds do pose a few more complications than the large-cap stocks that make up the S&P 500, so the delay is not unwarranted, ETF participants said. ETFs are similar to index-based mutual funds but trade on exchanges in real-time instead of being priced just once a day at the close.

Regulators must determine if an ETF’s trading should be paused only by a severe change in the fund’s own price or by a move in the fund’s underlying index. And some ETFs that are thinly traded or leveraged might need different trigger points than the 10 percent price change being used for S&P 500 stocks.

Though the industry still lacks a complete understanding of what happened during the crash, participants have increasingly focused on the interplay between the various computerized systems responsible for trading, pricing and creating ETFs rapidly in real-time.

For example, computers used by those who make a market in ETFs must be programmed to be on the lookout for the unusual but not unheard of situations when systems glitches prompt an exchange to cancel trades.

When the computer programs detect unusually large moves in stock or ETF prices, they scale back from offering bid and ask quotes because of the increased possibility of erroneous trades that will be canceled.

    “It’s the natural functioning of the market-making algorithms,” Gus Sauter, chief investment officer at Vanguard Group, another leading ETF manager.

    But on May 6, the computers pulled back so much that the only bids remaining on some trading platforms were so-called stub bids of a penny.

    Market makers generally place such bids in the exchange’s trading platforms as placeholders when they are not actively offering to buy or sell a security but may want to return to the market later in the day.

    Computer programs designed to seek out bargain bids, as well as automated stop-loss orders used by retail investors, then may have traded at the stub quote prices.

    “A lot of the algos are really just rote, even dumb, really just doing what they’ve been programmed to do, repeatedly,” Commodities Futures Trading Commission Chairman Gary Gensler said at Thursday’s hearing.

    ETFs are also less likely to be the subject of standing purchase orders from fundamental investors, who may request to buy a desired stock if its price ever drops a bit.

    “ETFs don’t usually have a lot of bids at some bottom-out price,” said Jim Ross, senior managing director in State Street’s (STT.N) ETF unit. “So the depth of the market makers’ book is much less.”

    ETF players have also focused on the decision by exchanges including Nasdaq OMX Group (NDAQ.O) and BATS Global Markets to stop sending orders to NYSE Euronext’s NYX.N Arca platform. More than 80 percent of ETFs are listed on Arca, where the largest portion of fund trading occurs on a typical day. (With additional reporting by Jonathan Spicer; Editing by Steve Orlofsky)

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