The Lessons of Knight Capital

NEW YORK ( TheStreet) -- The Knight Capital ( KCG) incident shows how exchange-traded funds may be victims of market disruptions.

Like the Flash Crash of May 6, 2010, the Knight Capital glitch had an effect on the ETF market.

The Flash Crash started in the E-mini S&P 500 futures market and resulted in a "systemic problem with market-wide mispricings" says Paul Weisbruch, vice president of ETF/Options Sales and Trading at Street One Financial.

A trade was executed to sell 75,000 E-minis in just 20 minutes, which led to selloffs in the ETF market as well. Mispricings in the ETF market became so extreme -- trading almost 60% from previous prices -- that ETFs accounted for 70% of cancelled trades during the Flash Crash, according to the CFTC- SEC report on the flash crash.

Giovanni Cespa and Thierry Foucault offer one explanation to the ETF price deviations in 2010 in their paper "Illiquidity Contagion and Liquidity Crashes."

Cespa says the paper "argues that in today's markets, as liquidity suppliers in one asset increasingly rely on the price of other asset classes to set their quotes, markets have become more intertwined."

High illiquidity in the underlying holdings can be transmitted to the ETF as "dealers in that market find the prices of the underlying to be poorly informative," says Cespa. The price discovery process can be disrupted by these "illiquidity spillovers," making it more costly for arbitrageurs to engage in the market, which "further impairs price discovery".

In the paper, Cespa found that "a liquidity crash seems to be much stronger for assets that are close substitutes," which was consistent with how ETFs were "relatively more affected by the Flash Crash than other securities".

Unlike the Flash Crash, the Knight Capital glitch was caused by one firm, with no major data outages or mispricings across the market. Instead, Weisbruch says, "The Knight Capital incident opened up an arbitrage opportunity for other firms whose pricing mechanisms were still properly in place."

Over 100 stocks experienced volume and price spikes, but nothing as severe as the price swings during the 2010 Flash Crash. However, some utility ETFs, whose underlying holdings were concentrated in affected stocks, saw massive jumps in volume and price. More-illiquid ETFs also saw spreads widen significantly after the Knight Capital glitch due to Knight pulling out as lead market maker.

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