Exchange-Traded Funds, Market Structure, and the Flash Crash

The author analyzes the relationship between market structure and the flash crash. The proliferation of trading venues has resulted in a market that is more fragmented than ever. The author constructs measures to capture fragmentation and shows that they are important in explaining extreme price movements. New market structure reforms should help mitigate such market disruptions in the future but have not eliminated the possibility of another flash crash, albeit with a different catalyst. The “flash crash” of 6 May 2010 saw some stocks and exchange-traded funds traded at pennies only to rapidly recover in price. There has been considerable effort to understand and isolate the “cause” of the flash crash with a focus on the precise chronology of events. This article instead focuses on the relationship between market structure and the flash crash without taking a view on its catalyst. My hypothesis is that equity market structure—specifically, the pattern of market fragmentation—is a key determinant of the risk of extreme price changes. Prices are more sensitive to liquidity shocks in fragmented markets because imperfect intermarket linkages effectively “thin out” each venue’s limit order book. Fragmentation is naturally measured by the actual pattern of volumes traded across different venues, but it can also be measured with respect to a venue’s quotation activity at the best bid or offer. Quote fragmentation captures the competition among traders for order flow and, thus, may be better a proxy for the dynamics of higher-frequency activity than a measure based on traded volumes. I began with a time-series perspective using intraday trade data from January 1994 to September 2011 for all U.S. equities and found that fragmentation now is at the highest level ever, reflecting the complexity of U.S. equity market structure today. Cross-sectionally, I related fragmentation positively to company size and the use of intermarket sweep orders, which are typically used in aggressive liquidity-demanding strategies by nonretail traders. I showed that ETPs are more concentrated than other equities and that fragmentation was much greater on the day of the flash crash. Regarding the relationship between market structure and the flash crash, I found strong evidence that securities that experienced greater fragmentation before the flash crash were disproportionately affected on 6 May 2010. This result is consistent with my hypothesis that market structure is important in understanding the propagation of a liquidity shock. Although quote fragmentation is related to volume fragmentation, the two measures are distinct and diverged on the day of the flash crash. Both volume and quote fragmentation measures are important risk factors in explaining the observed cross-sectional price movements during the flash crash. My analysis provides insight into why ETPs were differentially affected even though ETP trading is less fragmented than that of other equities. For ETPs whose components are traded contemporaneously, widespread distortion of the prices of underlying basket security prices can confound the arbitrage pricing mechanism for ETPs, thus delinking price from value. From the public policy viewpoint, the fact that fragmentation is now at its highest level ever may help explain why the flash crash did not occur earlier in response to other liquidity shocks; the rapid growth of high-frequency trading and the use of aggressive sweep orders in a highly fragmented market is a recent phenomenon. Current policy proposals will help mitigate future sharp drawdowns, but another flash crash, albeit with a different catalyst and in a different asset class, remains a possibility.