US ETP Exchanges Evolve

Ryan Sullivan, Vice President, Global ETF Services at Brown Brothers Harriman explores the NYSE’s new market volatility rules and what the SEC’s recent approval could mean for the ETF industry.

Since the market tumult of 24 August 2015, ETP (Exchange Traded Products) sponsors, authorized participants, and the exchanges have sought to improve the ability of these products to weather periods of volatility.  In particular, the NYSE (New York Stock Exchange) has been working toward changes since the events of last summer and as a result, on 5 July 2016, the SEC approved a proposal from the exchange that seeks to smooth out the open and re-open of a securities’ trading session.

The NYSE proposal effectively eliminates Rule 48, which was intended to improve trading efficiency during a period of extreme volatility.  When invoked, it exempted market makers from two key daily activities: having to make indications on a security’s opening price and to seek approval from exchange floor officials for that price.  These activities typically require manual intervention in opening securities on a case-by-case basis, it was believed that lifting these requirements would improve efficiency.  However, as we saw in August 2015, Rule 48 had the unintended effect of delaying the open for almost 50% of NYSE listed positions as pre-open indicators needed for price discovery were not available. It also hindered the exchange’s ability to re-open trading of securities following the halts that were implemented that day.  Rule 48 has been cited by ETP sponsors as a major factor in the disruptions of ETP trading on 24 August 2015, with BlackRock commenting that the rule ‘…received abundant criticism for hindering transparency because it suspends the mandatory dissemination of tape indications regarding the opening price range’.

In place of Rule 48 are a set of guidelines whose intent is to replace some of the manual workflows with more automation and clarity as to when changes in procedure would be enacted.  The proposed guidelines include:

  • Individual stocks to open without pre-market indicators if they were set to trade within 5% of their previous day’s close
  • On volatile days, those shares could open as long as their prices were within 10% of their previous close
  • The exchange could declare a volatile day and go to the 10% guideline under three scenarios:
    1. Futures contracts on the Standard & Poor’s 500 Index are pointing to an open more than 2% away from the closing price the prior day
    2. If the exchanges are attempting to reopen after a market wide trading halt (circuit breaker)
    3. If the exchanges determine it is necessary to maintain a fair and orderly market

The new guidelines should be beneficial for both market makers and ETP sponsors.  By establishing a more rule-based approach to managing the open or re-open of securities, the exchange can eliminate some of the confusion the invocation of Rule 48 created.  Market makers will now have more clarity as to what constitutes a volatile market in-terms of price swings from prior-day and when pre-open indicators will be required.

Also, this change should streamline the open or resumption of trading by reducing the manual intervention that Rule 48 required.  Some of the divergence in pricing on 24 August 2015 in ETFs was a result of the underlying securities not being open, while the ETF was.  Many ETFs are listed on the NYSE Arca, which does not follow Rule 48, meaning that while some of their holdings were delayed in opening, the ETF was traded, leading to severe drops in price.  The removal of the rule from the NYSE platform should better align the treatment of the fund with its underlying constituents. However, it’s important to note that it may be months before the exchange is able to implement the technology upgrades needed to support the new guidelines.

More Changes on the Horizon

In truth, the ETP ecosystem has, in general, already improved communication with some success – on the day the Brexit vote results were announced, intra-exchange communication helped manage the ensuing volatility and no ETPs were halted from trading.  Additionally, the NYSE has also already implemented changes in some of its rules where permitted and offered additional proposals go beyond those covered here.

Across the ETP market, ETP sponsors and the regulators have called for more standardization in the way securities are opened, re-opened and closed.

The ETP industry should expect to see further announcements and proposals not only from the NYSE, but from NASDAQ and BATS as well, which will seek to harmonize some of the daily procedures and rules to provide further resiliency in volatile markets.

Note: Parts of this post originally appeared in the 2016 BBH Regulatory Field Guide

About Ryan Sullivan

Ryan Sullivan joined BBH in 2015 and is a Vice President with BBH’s Global Exchange Traded Fund (ETF) Services. In this role, Ryan seeks to consult and partner with US based ETF sponsors and new entrants to the ETF market, aligning BBH’s expertise with their ETF development efforts.  Prior to joining BBH, Ryan held multiple roles for Charles Schwab Investment Management within the Product Development & Strategy and Product Management groups. Ryan started his career at State Street Bank and has more than 13 years of financial services experience, including 8 years within the ETF industry. Ryan graduated from Saint Anselm College with a Bachelor of Arts in Politics and has a Master of Science in Finance (MSF) degree from the Sawyer Business School at Suffolk University.