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I was not surprised to learn that more than half of the products most affected by yesterday's trading meltdown were ETFs and ETNs. Nearly 70% of trades canceled in the wake of the tech snafu yesterday were in exchange-traded products, according to The Wall Street Journal.
Scanning the list, I learned that some of the most affected products yesterday were the iShares Russell 1000 Value Index Fund (IWD - commentary - Trade Now), E-TRACS UBS Bloomberg CMCI ETN (UCI - commentary - Trade Now), Elements Benjamin Graham Large Cap Value ETN (BVL - commentary - Trade Now) and the Rydex Inverse 2x S&P MidCap 400 ETF (RMS - commentary - Trade Now).
I didn't have to check the list, however, to have a sense of what the most affected symbols would be. Two of these products have one very important thing is common: exceptionally low average daily trading volumes. UCI and BVL have three-month average daily trading volumes of 7,000 shares and 305 shares respectively.
Active traders shouldn't touch either of these products with a 10-foot pole on normal trading days. In illiquid ETFs, often the only thing standing between you and a penny bid are the algorithms of a lead market maker. If technical problems occur or a market meltdown ensues, you do not want to be one-on-one with these trading programs.
How do I know? I used to be one of those market makers. After a brief stint in options trading and a year in equities, I became a member of the American Stock Exchange and a lead market maker for a handful of ETF products. At the time, I worked for one of the seven specialist firms that had operations on the NYSE and Arca. While we were the smallest firm, we were one of the biggest participants in the growing ETF listings industry.
I had the unique experience of entering this arena at an eventful time. The American Stock Exchange faced imminent extinction, and the ETFs listed there were to be transferred -- along with the market makers -- to the electronic NYSE Arca platform. While I would still be working for a stock exchange and a specialist firm, I would be making markets from a trading desk on Broadway. I was 24 years old.
Changes were also under way on the New York Stock Exchange and NYSE Arca. After converting to a new "hybrid" marketplace, specialist firms had to create new "front-end" trading algorithms to interact with the data feed from the exchange. A team of highly accomplished computer programmers swarmed our offices and struggled to explain to traders how we would now create two-sided markets with advanced algorithms.
One of the features of the new system were three different "quote sets," which could be used at different times in the day to automatically generate bids and offers. Since, as a lead market maker, I had to be willing to buy and sell continuously, providing two-sided markets, the program would generate markets automatically, depending on my customized settings.
As one of the "new guys," I was given a book of products that, generally, traded infrequently. This provided me with a way to get my feet wet and see illiquid trading products in action. Some of the products I traded were so illiquid, in fact, that they were delisted because of lack of investor interest not long after I made my career change.
One of the first things you notice as a market maker in an illiquid ETF is that you are not just the first line of defense -- you are often the only line of defense. In many of my products, the entire "book" (all existing bids and asks) was composed of my orders. I was the bid, I was the ask ... I was the only player in town.
In order to provide a fair and orderly market - and to play by exchange rules and attract new ETF listings -- your markets had to be reasonable. This meant that your bid and ask generally have to be close to net asset value. The minimum size of the bid and offer was 200 shares.
From there, I would layer the book outward, increasing order size as I got further from NAV. On "quote set 1," I would have a tighter market programmed in, which automatically provided bids and asks close to NAV and layered the book heavily as you moved outward. On "quote set 2," these quotes would be slightly further away. "Quote set 3" was designed for when you really wanted to get out of the way - when things went haywire and you wanted to widen your markets on news, or close to the open or close.
Unusual trading volume would trip me from one quote set to the next. This would help to ensure that I wouldn't get pounded if orders started flooding in. It would give me time to regroup and hedge with components to lower exposure.
Since many of my products were illiquid, markets would disappear completely if my algorithm were to be turned off. In that case, products would likely trade at a penny or $999.99, depending on whether someone was looking to buy or sell. If this happened because of a technical error, someone would simply request a "bust or adjust," and the trade would be corrected.
I feel confident that firms felt this panic take shape yesterday. As orders flooded in, algorithms widened out quotes in illiquid ETF products, and perhaps some systems went down in their entirety. Ridiculous trades hit the tape because no one was able -- or willing -- to provide two-sided markets.
This is what customers wanted. Speed was demanded over quality of execution. We wanted lightening-fast markets, and firms responded by reducing the humans and increasing the technology. Whether we like this decision or not in retrospect, traders must face the reality of the new changed world.
When recommending ETF products, the first thing I look at now is liquidity. I think back to those days and those products, and I know that liquidity is the most important factor. You don't want to be alone when trying to trade an ETF, and the more participants, the better. Why would you want to trade a product when you know that only one other person is going to decide where you can buy and sell it -- when one market maker is the only show in town?
Average daily trading volume is an important indicator of liquidity. The higher the better, since it generally indicates that there is elevated investor interest, and there are plenty of people looking to make and improve marketplaces.
Avoid meltdowns like yesterday, or technical troubles that occur spontaneously, by choosing ETFs that involve the most trading participants. Choose liquidity. |
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狗仔卡
发表于 2010-5-7 05:00 PM
提升卡
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喧嚣卡
变色卡
发表于 2010-5-7 06:39 PM
