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After Knight, Unfair Knocks

After Knight, Unfair Knocks

ETF liquidity, electronic trading and rogue algorithms all came under renewed scrutiny in the wake of the Knight Capital debacle. But the pundits got it wrong: The ETF market is liquid and sound.

The recent event at Knight Capital, which was in reality nothing more than a technology glitch, once again gave various media outlets and talking heads an excuse to theorize about issues of liquidity in ETFs and the effects of electronic trading in our market place.

Let’s take a breath, looks at the facts and not over react. All is well with ETF liquidity and our capital markets system, which is the best in the world.

Knight Capital is one of the largest and more active ETF market making firms in the industry; they commit seed capital to launch new ETFs and commit their firm’s capital to making markets in ETFs. They work closely with issuers to provide quality markets to ETF investors. They are very good at what they do, but they are not the only ones doing it. The very structure of an ETF allows for multiple liquidity providers called APs (Approved Participants). There can be ten to twenty APs per ETF. If one goes away, there are plenty of others to pick up the slack in a seamless process for investors.

 There was a rush to judge the quality of the ETF market by looking at the spreads just prior to and just after the Knight debacle. There was an assumption by some critics that larger spreads would remain and liquidity would be lost.  Again, a multitude of market participants operate in the ETF market reducing any effect of a decrease in participation by Knight.

Also note that the quoted spread is not that essential in determining your ETF trade. You want to look at the price of the ETF versus the value of the underlying index. Also, to avoid any issues with quoted spreads, ETF issuers have been educating investors to use limit orders when buying.  A limit order puts the advisor/investor in charge of the pricing.

Please do not, I repeat do not, use market orders!  If you do then the quoted spread can be a problem for you. Avoid it and use limit orders only.

Liquidity in ETFs does not rest solely at the quoted price. Liquidity can reside away from the market.  If you call your trading desk, any of the APs in the ETF or even the ETF issuer itself you can find liquidity. Seek it properly and you will find it.

The rogue algorithm that ran through some 140 stocks on August 1st has raised concern about electronic markets. Let’s be clear the algorithm that Knight was installing was for a client. Our markets and market structure have always been designed for investor interest and investor protection. The markets are as safe now for investor as they have ever been.

Do you remember when there were two distinct markets; one for institutions and one for retail? How we hated to see a large block print on the tape at the same price as our limit order but we did not get an execution.  The markets where not fair in the past; today, because of technology and regulation, they are the fairest markets in the world.

It was the big institutional buy-side firms that first asked for algorithms, they wanted their institutional trade to look like a retail trade, so there would be no front running whenever a large block printed.  Those were dangerous days for investors.

Yes, today’s markets have challenges because of technology, but don’t we all. Our cell phones drop calls, email servers go down, computers crash; living in a digital age affects all aspects of life including the stock market. But technology also provides an efficiency that we cannot get any other way.

In the case of the ETF market, the only damage done was by the media. Liquidity was not lost, trading continued and investors had access to their investments at all times. The same cannot always be said for mutual fund investors who have to wait till the 4pm bell before they can get pricing for their investment.

ETFs and electronic markets are investor friendly, all you need to do is learn more on how they work and they will work for you.

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