TRADING STRATEGY Victor Lin 415 836 7643

Trading Strategy Perfect Storm Leads to ETF Trading Halts

30 September 2015

Market Commentary

Confluence of Factors Contribute to Halts

Key Points 

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During a volatile trading session on August 24th, 327 ETFs were halted a total of 1116 times as the stock market experienced its biggest drop since 2008. While most of ETF trading (~99%) was executed as normal and the halts were not systemic, there were some issues that surfaced amidst the extreme market uncertainty. Although many stocks suffered trading halts as well, much of the focus was on ETFs due to the divergence from the value of their underlying baskets.

During a volatile trading session on August 24th, 327 ETFs were halted a total of 1116 times as the stock market experienced its biggest drop since 2008. Overall, ETFs traded close to $270bn on that day, almost 4 times more than recent averages. While most ETF trading was executed as normal, there were some issues that surfaced amidst the extreme market uncertainty. Although many stocks experienced severe declines and trading halts as well, there was additional scrutiny on the ETFs that experienced halts as the ETFs diverged from the value of their underlying stocks. Exhibit 1: Trading Halts in ETFs On August 24th

Ultimately, it was a confluence of factors that led to the issues in ETF trading. The extreme market volatility, disruption in the underlying markets (lack of opening price indications, delays, trading halts) that hindered ETF arbitrage and sourcing additional liquidity, and aggressive onesided order flow created problems in certain ETFs – generally with less average daily liquidity than the most popular ETFs.

Source: Credit Suisse Trading Strategy

Proper functioning of ETFs relies on the ability of market makers to effectively value an ETF’s holdings and potentially hedge any exposure. While ETF trading functions normally most of the time, it can still be subject to disruption by extreme market volatility in an ETF’s underlying holdings, inability of market makers to hedge or offset exposures, or the risk in extremely volatile market conditions. On August 24th, several factors contributed to the market disruption. In this report, we explore the unique set of circumstances around the trading halts.

Edward K. Tom

Victor Lin *

Ana Avramovic

Mark Buchanan

[email protected] (212) 325 3584

[email protected] (415) 836 7643

[email protected] (212) 325 2438

+44 207 888 0908

* primary author (

[email protected]

TRADING STRATEGY Exhibit 2: S&P 500 Stocks Slow to Open on August 24 th

Confluence of Factors Contribute to Halts Fears, Delays, Halts Lead to More Uncertainty and Wider Spreads Concerns stemming from China’s economy led to steep declines in Asia, Europe, and the U.S. markets (S&P futures were limit down prior to the market open) on August 24th. Subsequently, NYSE decided to invoke Rule 48 and utilize a manual open (relying on specialists as opposed to algorithms matching open order flow) in anticipation of a volatile session of trading. The rule means designated market makers do not have to disseminate stock price indications before the open. While this rule is meant to smooth the open in a volatile market, the lack of stock pricing information was a detriment for valuing ETFs, especially as S&P futures (a common hedging tool for ETFs) were halted.

Source: Credit Suisse Trading Strategy

Exhibit 3: Single Stock Spreads Spiked As Well

Additionally, many stocks took longer to open while ETFs were already trading. Exhibit 2 shows that only about 65% of the S&P 500 (by index weight) was open for trading at 9:35AM, and it took nearly 30 minutes for all the stocks in the S&P 500 to open. In addition, stock bid-ask spreads widened amidst the early morning volatility (see Exhibit 3) and several stocks were halted soon after the open (almost 90% of the domestic equity ETFs experiencing halts contained a stock that was halted). The uncertainty in the underlying stocks tracked by ETFs made it difficult for market makers to properly value ETF holdings (resorting to less precise, manual estimates) in order to make the tight markets ETFs are typically known for. Market Fear Stresses ETF-Underlying Link Most of the time, ETF prices are tightly bound to the basket of stocks they track through the process of arbitrage – either using the creation/redemption process (which allows authorized participants to arbitrage stock basket-ETF differences) or similar products. However, that process relies on transparency and continuity; without the means to trade and accurately price securities, the arbitrage process breaks down and can lead to pricing disconnects between the ETF and the underlying. In the absence of the arbitrage mechanism, the ETF is likely to trade in a manner that reflects immediate supply and demand dynamics.

Source: Credit Suisse Trading Strategy

This happened on August 24th as several ETFs experienced severe declines seemingly out-of-line with their underlying stock baskets, triggering multiple trading halts as they dropped an average of 30% from the previous day’s close. While the declines were temporary and the ETF prices rose back in line with the underlying stocks, the correction was also hindered by more trading halts on the way up.

Exhibit 4: Halted ETFs Represent About 20% of ETF Market 100% 90%

$433bn

327

$1.6tr

1445

80% 70%

60% 50% 40% 30% 20%

10% 0%

ETP AUM Not Halted

Source: Credit Suisse Trading Strategy

# of ETPs Halted on Aug 24

20% of ETFs Experienced Trading Halts, Mostly Less Liquid While the rightful focus of attention is on the ETFs that suffered trading halts, it is important to note that most ETFs traded without interruption. In terms of both assets and number of products, about 80% of ETFs had continuous trading throughout the day (see Exhibit 4). Additionally, out of the $270bn of ETF volumes that traded, the ETFs that experienced trading halts represented 6% (~$16.5bn). While most of the affected ETFs were on the smaller side in terms of AUM and average daily value traded, there were some that were moderate to larger sized as well (see Exhibits 5 and 6).  The largest ETF affected was IVV (iShares Core S&P 500 ETF) with close to $70bn in assets. The median size of the halted ETFs was $518mm in assets. 2

TRADING STRATEGY 

Exhibit 5: ETFs With the Most Halts on August 24th

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The ETF halted the most number of times (12) was HDV (iShares Core High Dividend ETF). In total, 14 ETFs were halted 10 or more times. On average, the affected ETFs trade about $13mm per day. The median value is even lower – just $1.7mm per day. Only 27 ETFs that trade more than 500k shares experienced halts.

Exhibit 6: Halted ETFs Were Mostly Small, But a Significant Amount Were Sizeable

Source: Credit Suisse Trading Strategy

Source: Credit Suisse Trading Strategy

Exhibit 7: Most Halted ETFs Tracked U.S. Equities

Although Focus on Domestic Equity ETFs, Halts Not Systemic Of the affected ETFs, close to two-thirds of the products track U.S. equities (see Exhibit 7). These U.S. equity ETFs also triggered 75% of the ETF trading halts experienced on the day. However, the focus on domestic equity ETFs was a likely function of the challenges experienced in the U.S. stock market – namely the single stock trading halts and lack of pricing indications at the open. Outside of the focus on domestic equity ETFs, the trading halts were not specific to any particular provider or any other easily distinguishable characteristic. For example, even if we look just at the subset of vanilla, large cap ETFs (which should perform very closely due to similar underlying stocks), there were several ETFs of different sizes/liquidity that experienced halts while the others traded as normal.

Source: Credit Suisse Trading Strategy

Exhibit 8: Only Certain ETFs Were Affected, And Not Uniformly. For Example, Some Vanilla, Large Cap ETFs Traded Normally – Others Experienced More Severe Declines and Halts 105 100

Normalized

95 90 85 Halted

80

Not Halted

75 70 9:30 AM

9:45 AM

10:00 AM 10:15 AM 10:30 AM 10:45 AM 11:00 AM

Source: Credit Suisse Trading Strategy

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TRADING STRATEGY ETF Market Maker Obligations Market makers are obligated to make two-sided markets to buy or sell the ETF as set forth by the parameters in NYSE Arca Rule 7.23. Lead market maker have enhanced quoting obligations and are required by exchange rules to provide the “best” price available across the secondary market a specified percentage of time. They also have requirements including a minimum displayed size, minimum quoted spread and participation requirements for opening and closing auctions. The number of registered market makers varies by ETF (usually by size and type), but is typically around 4 or 5. Number of APs That Are Registered Market Makers in ETFs

Challenging Liquidity - Spreads in Halted ETFs Especially High The increased risk of the day, lack of transparency and wider spreads in the underlying stock market, and potential for significant order imbalances (e.g. aggressive selling in response to market declines) meant ETF market makers had to be extremely careful in how they allocated their risk capital. When the market is dropping as severely as it did the morning of August 24th, market makers also need to be wary of the chance of cancelled trades. If it’s a trade they choose to hedge, the risk of the trade being cancelled could potentially leave them exposed on the hedge. As a result, spreads in ETFs widened and the ETF-market was operating with less efficiency and liquidity than usual. The ETFs that triggered halts were amongst the ETFs where spreads widened the most. Exhibit 9 shows the dramatic increase in bid-ask spreads in the affected ETFs during the beginning of the U.S. trading day on August 24th relative to the previous trading day. On average, bidask spreads in the affected ETFs on that morning were nearly 40 times as wide as the previous morning, and the market depth very thin. For comparison, the rest of the ETF universe saw spreads about 4 times as wide as the previous morning (see Exhibit 10). Exhibit 9: ETFs Experiencing Halts Had Dramatic Widening of Spread At Open

Source: ICI

Exhibit 10: Halted ETFs Had More Significant Increases in Bid-Ask Spread Than Other ETFs

Source: Credit Suisse Trading Strategy

Source: Credit Suisse Trading Strategy

Aggressive Selling Reflects Order Imbalances in Halted ETFs If there were just wider spreads and a more challenging liquidity environment, that alone likely wouldn’t have triggered severe declines and trading halts. Indeed, most ETFs traded without issue as we highlighted earlier. One factor common to many of the halted ETFs was heavy flow relative to typical trading in the ETF. As Exhibit 11 shows, the ETFs that experienced halts had a median value of 67% of average daily value traded in just the first half hour of August 24th alone – which is especially notable given that many were halted for a good portion of that time. In contrast, ETFs that did not experience a trading halt had a median value of 26% of average daily value traded. Exhibit 11: ETFs Experiencing Halts Received Larger Orders Relative to Other ETFs

Source: Credit Suisse Trading Strategy

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TRADING STRATEGY However, we can also see in Exhibit 11 that there were many ETFs that traded larger amounts at the beginning of the day and were not halted. It seems likely to us that these ETFs did not have as severe of order imbalances (relative to average daily traded value) as the ETFs that did experience halts. Exhibit 12: Histogram of Halted ETFs Hitting Intraday Lows Shows Most Had Troughed By 9:45AM

Source: Credit Suisse Trading Strategy

Order Restored, But Upward Halts Protract Recovery Most of the affected ETFs bottomed out by 9:45AM (see Exhibit 12) and began recovering as more of the underlying stocks opened for trading on NYSE and the relationship between ETFs and underlying stock gained clarity. Some ETFs like IVV (iShares S&P 500) were back in line with NAV by about 9:45AM while others like HDV (iShares Core High Dividend) were not back in line with NAV until closer to 10:40AM. The delays in moving back closer to NAV were due mainly to halts triggered as the ETFs were reversing earlier declines. Overall, it was not until after 10:30AM that most of the affected ETFs were trading back in line with their underlying (see Exhibit 13). In total, about $1.9bn traded in the first 15 minutes while the affected ETFs were mostly in decline, which was 0.7% of the total value traded in ETFs that day. Overall, $4.6bn traded in the first hour of the day in ETFs that experienced halts, or about 1.7% of total ETF value traded. Exhibit 13: Most ETFs Experiencing Halts Had Fully Recovered by 10:30 AM

Source: Credit Suisse Trading Strategy

System Worked as Designed, But Some Unintended Results The single stock trading halts worked as they were designed for the most part – to prevent wild price swings that were separated from fundamentals by allowing traders to pause and assess the situation (see Lessons Learned from the Sell-Off). It’s quite possible the sell-off would have been even more severe without the circuit breakers. However, there were some unintended results from the design that emerged - ETFs seem to be more susceptible to disruption when a large amount of stocks are halted. Additionally, the invocation of Rule 48 (meant to smooth the open of stocks) and delay in the opening of stocks on the NYSE exacerbated the issue as the lack of pricing data made it even more difficult for market makers to efficiently trade ETFs. In general, we can see the outline of the factors leading to the issues in trading experienced by certain ETFs: 

Fearful Markets (Increased volatility, wider spreads, extreme imbalances): Fearful, uncertain markets were in decline (remember, the S&P futures were down 7% - which would have been enough to bring cash markets to a halt); heightened volatility 5

TRADING STRATEGY typically leads to wider bid-ask spreads in stocks, larger orders/more active trading, and more imbalanced order flow. ETF market makers’ risk capital is limited, and these conditions can be challenging in providing liquidity. Depending on the level of risk aversion, market makers would be wary of allocating a significant amount of risk in something that may not be easily paired off. 

Lack of data in underlying stock negatively impacts ETF liquidity: ETF market makers need to be confident in the accuracy of their valuations of the ETF’s underlying securities. The largescale delayed open in underlying stocks, single stock trading halts, and lack of pricing information (Rule 48) made ETF arbitrage and sourcing additional ETF liquidity more difficult. Consequently, the affected ETFs were trading more like independent securities rather than vehicles deriving their value from underlying stocks.

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Perfect storm: For the most part, the affected ETFs had relatively small average daily volumes – even though several were sizeable from an asset perspective. Most of the ETFs were likely not used to seeing imbalanced orders of such magnitude. Even as liquidity dried up and spreads widened to extreme levels (which in theory should be a deterrent to trading), sell orders accumulated. The aggressive selling combined with the wide spreads and difficulties in the ETF arbitrage mechanism led to extreme price dislocations and trading halts. To provide liquidity in a declining market, market makers need to feel confident they can pair their trade off quickly or that any hedging trades that they put on are accurate and not put them at risk.

Are New Regulations Needed? From a relative standpoint, the disturbances in the ETF market on August 24th were a small part of the massive volume that traded that day and mostly relegated to less frequently traded ETFs. However, the trading halts are also a strong reminder of the important link between ETFs and the underlying securities they derive their value. When the transparency of the underlying is impacted, the ETFs are vulnerable to disconnects and caution should be exercised:  For example, market orders (including stop-loss orders as mentioned in several media reports) should be used with caution, particularly in volatile markets.  Additionally, one should check for wide bid-ask spreads, which are usually indicative of a lack of information, lesser liquidity, and greater risk. Does the unique way in which ETFs operate mean ETFs should be regulated differently?  It’s difficult to say as most ETF trading occured without issue and as August 24th reminded us, the introduction of new regulation has the potential to bring about some unintended consequences.  Additionally, some argue that ETFs should be even more closely linked to their underlying – yet the main issue was not the mechanics of the link, but the disruption in the underlying markets.  Liquidity and risk: Undoubtedly, a lack of immediate liquidity played a big factor in the issues experienced as well. However, there’s no easy fix for increasing liquidity. Liquidity providers are often risk averse (perhaps more so in the current regulatory environment) and looking to capture small spreads without using significant capital. Regardless, investors should remain mindful that vigilance in the trading process is just as important as any regulations that can be introduced. 6

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Credit Suisse Trading and Derivatives Strategy Edward K. Tom Managing Director

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Edward K. Tom Head, Equity Derivatives Strategy US +1 212 325 3584 [email protected]

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