Most Mondays we all just want to ease into the week, uneventfully.
But on one particular Monday, a large overnight selloff in the Chinese equity market had many market observers anticipating a less than smooth start to Aug. 24, 2015. Shortly after the opening bell, the Dow Jones Industrial Average Index tumbled 6% and the S&P 500 Index fell 5%. Many stocks dropped more than 20%.
Shortly after, the Chicago Board Options Exchange Volatility Index or VIX spiked to an intraday high of 53 — its highest recorded level outside of the 2008-09 financial crisis, according to Bloomberg (Aug. 24, 2015). If it hadn’t already, the extraordinary nature of the situation hit home when the New York Stock Exchange invoked the rarely then used Rule 48.
Designating an extreme market volatility condition, Rule 48 suspended the requirement that stock prices be announced before trading commenced. The idea was to speed up the market’s open and mitigate some of the volatility.
But complicating matters, stock exchange volatility rules, created after the 2010 Flash Crash, went into effect as well. As a result, trading on about 100 stocks and 300 exchange-traded funds was temporarily halted, sometimes repeatedly.
Walking a Tightrope
Under normal market conditions Authorized Participants, typically large financial institutions, will act as arbitragers when an ETF’s price diverges from its net asset value.
However, on that day, APs largely were flying blind due to dozens of halted stocks and limited price information. Without accurate reads on the prices of the underlying basket of securities, many ETF market makers widened their spreads — the difference between their buying and selling price — or withdrew bids entirely.
The result was an irregularly thin market combined with a backlog of orders piling up during the halts, which caused some ETFs to trade more than 40% away from their NAVs, many of which were down to a lesser degree. (See research from the BATS Exchange.)
How Times Have Changed
About six months after that frenetic Monday opening, the NYSE took several steps to prevent another one. It started by eliminating Rule 48. More importantly, the NYSE improved its dissemination of opening imbalance information by offering greater transparency to the market, improving opening procedures, and increasing the market’s resiliency during times of stress.
Thereafter, the NYSE, along with Nasdaq and Bats, enhanced their limit-up/limit-down (LULD) rules to better handle openings across all the exchanges when a security hits a “circuit breaker.” LULD now uses the prior trading session’s close price for the reference on the next session’s LULD bands.
Before that, the midpoint between the opening bid/ask prices was used, which could have thrown off trading band numbers. The new rules eliminate the time periods when securities can trade without LULD bands in place. They also standardize automated re-openings after a trading halt and erroneous execution rules when LULD bands are in effect.
Put to the Test
Later that week of Aug. 24, 2015, the market and VIX stabilized and liquidity returned to more normalized levels. The experience demonstrated that we needed better exchange rules to ensure liquidity and orderly halts/reopens during periods of extreme volatility.
Fortunately, the market’s formal and informal responses to extraordinary events — such as the Brexit vote and the surprising outcome of the US elections — seem to have improved since then with refined volatility-induced rules and better communication among market participants.