As republished on March 23, 2016 by The National Law Review.

In the roughly ten-year period from 2005 to late 2015, the aggregate assets in exchange-traded funds (ETFs) have increased from around $300 billion to $2.1 trillion.¹ With this increase in popularity has come an increase in regulatory scrutiny.

On August 24, 2015, in what has been dubbed a “Flash Crash,” the stock market experienced an abnormally high amount of early-day sell-offs and the Dow dropped over 1,000 points within minutes after opening. This Flash Crash had a significant impact on ETFs, as noted by former Commissioner Luis A. Aguilar:

[D]ozens of equity ETFs had their prices plunge far below the values of the indices they were designed to track. By one estimate, trading in ETFs was halted more than 1,000 times that morning pursuant to the limit up/limit down rules implemented in the wake of the 2010 flash crash, and this accounted for approximately 85 percent of all trade halts that day.²

For regulators already keeping an eye on the rapid proliferation of ETFs—in terms of both the creation of ETFs themselves and of the aggregate assets—the Flash Crash signaled a need for action. Within weeks, the Securities and Exchange Commission (SEC) called for enhanced scrutiny of ETFs. In an October 2015 speech to the SEC’s Investor Advisory Committee, Commissioner Aguilar posited that “[i]t may be time to reexamine the entire ETF ecosystem.”³ Less than a month later, in a speech at Harvard Law School’s Fidelity Guest Lecture Series, Commissioner Kara Stein offered similarly bold language, stating that “[n]ow is the time to be asking the hard questions about ETFs.”⁴ More specifically, Commissioner Stein called for analyses of “the roles that all of the individual players in this ecosystem play” as well as “how ETFs trade, as compared to mutual funds, and whether the way algorithmic traders utilize ETFs poses concerns to investors placing their retirement savings in these products.”⁵

On January 11, 2016, the SEC’s Office of Compliance Inspections and Examinations released their examination priorities for 2016. Under the category of “Protecting Retail Investors and Investors Saving for Retirement,” the priorities included:

[E]xamin[ing] ETFs for compliance with applicable exemptive relief granted under the Securities Exchange Act of 1934 and the Investment Company Act of 1940 and with other regulatory requirements, as well as review the ETFs’ unit creation and redemption process. We will also focus on sales strategies, trading practices, and disclosures involving ETFs, including excessive portfolio concentration, primary and secondary market trading risks, adequacy of risk disclosure, and suitability, particularly in niche or leveraged/inverse ETFs.⁶

On January 21, 2016, SEC Chair Mary Jo White addressed the topic, confirming that the SEC is “closely reviewing how [exchange-traded funds] trade in the secondary market.”⁷ Importantly, Chair White provided insight as to how the SEC would approach its analysis of ETFs, stating that ETFs will be reviewed using the Flash Crash as “an important ‘case study.’” The basis for this case study is a research note (the Note) published by the staff of the SEC’s Office of Analytics and Research on December 29, 2015.⁸ The Note, entitled “Equity Market Volatility on August 24, 2015,” contains “empirical data and other information to help assess trading on August 24, including several issues that have been debated among market participants and in the media [including] the effects of market volatility on trading in exchange-traded products.” There are several statements and data points within the Note that may shed light on the SEC’s focuses, concerns and understanding of ETFs:

• During a control period from July 27, 2015 through August 21, 2015, “ETPs⁹ were less volatile than Corporates.” However, on August 24, “ETPs as a class experienced more substantial increases in volume and more severe volatility than Corporates.” Specifically, during the Flash Crash, “19.2% (288) of ETPs experienced price declines of 20% or greater, while only 4.7% (280) of Corporates experienced such declines.”

• Within the more volatile world of ETPs during the Flash Crash, “individual ETPs varied widely in terms of their volatility” and “[e]xtreme volatility seemed to occur idiosyncratically among otherwise seemingly similar ETPs.” For example, “SPY . . . traded at a premium to its NAV until 9:37, while the next largest ETP—the iShares Core S&P 500 (‘IVV’)—traded at a substantial discount to the SPY, E-Mini, and SPY NAV until 9:43.”

• During the Flash Crash, “83% of [limit up/limit down (LULD)] halts . . . were in ETPs, even though they represent less than 20% of the securities subject to the LULD Plan that were traded that day.”

• One of the metrics that proved to be an accurate predictor of volatility and LULD events was ADV turnover rate, defined as “the ratio of average daily volume in the secondary market for an ETP to its shares outstanding.” Data shows that “[t]he US Equity ETPs in the two least volatile groups exhibited ADV Turnover Rates (3.8% and 5.3%) that are at least three times higher than the rates for the most volatile groups (0.6% and 1.0%).” Further, when “Large” and “Mid” sized U.S. Equity ETPs—which experienced a total of 322 LULD halts during the Flash Crash—are divided into four bins ranging from “lowest” ADV turnover rate to “highest” ADV turnover rate, all but six of the 322 LULD halts fall within the three lower turnover bins.

At the annual SEC Speaks conference on February 19, 2016, Commissioner Stein again addressed ETFs, noting that their rapid growth “is astounding and potentially good—as long as risks are identified; market participants and investors are informed; and appropriate safeguards are in place.”¹⁰ She further noted the growth in “volume, type, and variety” of ETFs and expressed concern that “the risk presented by some of these new products may not be fully understood by those who have invested in them.” However, she also expressed concern that “even plain-vanilla, equity index ETFs may present risks that are not always anticipated or fully understood.” As a basis for this concern, she reiterated the SEC’s focus on the August 24, 2015 Flash Crash which, she claimed, showed that “many ETFs behaved in an unpredictable and volatile manner.” With respect to enforcement priorities, Commissioner Stein suggested¹¹ that the SEC consider whether “investors have adequate disclosure of [exchange-traded products’¹²] risks,” “how these products are being marketed and by whom,” and whether certain exchange-traded products “are even suitable for buy-and-hold investors.”

In light of the foregoing statements and data, it is clear that the SEC has identified ETFs as an area of increased scrutiny. ETFs will be an examination priority this year, and may receive increased attention from the SEC’s Division of Enforcement. Simultaneously, the SEC will continue to rely on its industry experts and empirical analysis to enhance its understanding of these products.

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