Let’s not make a volatile situation worse

Financial markets rang in the new year with a slide in global and U.S. stock markets that should serve as a warning sign for advisers and clients alike.

For financial advisers, the market turmoil must seem like déjà vu all over again. More importantly, the swoon offers a sobering reminder that unexpected market roller-coaster rides remain as real a threat in 2016 as they were in 2015. Specifically, recall another Monday morning, Aug. 24, when the most actively traded ETF plummeted more than 5% below its previous closing price — and that was before the market even opened.

The Securities and Exchange Commission rehashed the details of the August debacle in an exhaustive report noting various technical and possible human failures that led to the market disruption, which saw 19% of all ETFs decline by 20% or more.

But what exactly happened? That we still do not know, which could be the most damning detail to emerge from the SEC’s 88-page report.

“What should really make you nervous is that they still don’t know what the hell happened,” Bob Rice, chief investment strategist at Tangent Capital, told InvestmentNews senior columnist Jeff Benjamin.

For financial adviser Theodore Feight, there’s a more unnerving question: How could surprise tech, and possibly human, snafus result in the loss of $5.5 million of his clients’ money within three minutes of the opening bell?

Said Mr. Feight, the owner of Creative Financial Design, “Aug. 24 shook me to the core.” The market sell-off spurred him to revise the whole way he trades ETFs in client portfolios.

One area regulators should consider in their guidance for creating protections in market volatility is taking a closer look at the safeguards already in place.

BAD SAFEGUARDS

Ironically, a contributing factor to the massive drop in ETF prices on Aug. 24 was the fact that security checks put in place to prevent disruptive sell-offs on the New York Stock Exchange may in fact have contributed to even more rapid declines.

The SEC report noted that the drop in ETF prices was exacerbated when nearly half the underlying securities held by ETFs didn’t start trading when the NYSE opened. The lack of trades set off a ripple effect of more trading halts — 1,278 to be exact — that led to more volatility. Are the safeguards currently in place working as intended to buffer investment portfolios from market crashes? At the very least, let’s make sure current systems will not make volatile situations even worse.

Of particular concern are stop-loss orders that are locked in place before markets even open. Mr. Feight saw financial markets barrel through all the red lights and run past his stop-loss orders to turn 15% stops into 30% stops before he could find an exit ramp. Better understanding of abrupt jolts in the market is needed, and regulators may need to study whether keeping stop-loss orders overnight is a wise move. Advisers too must take greater responsibility in communicating to clients the potential risks of overnight stop-loss orders.

With the speed of modern-day trading, regulators also may want to take a closer look at whether trading in ETFs should be delayed until the underlying securities of those ETFs are open for trading. As market participants learned after the 2010 flash crash, which saw the Dow drop nearly 1,000 points in minutes, the installation of circuit breakers to limit and stop trading when securities experience large market moves can help provide some stability.

A final point on timing: The weeks from Christmas and Hanukkah until the New Year’s holiday are often prime times for publishing news items that companies or institutions want out of the spotlight.

The timing of the SEC report seems curious. Why introduce an 88-page report over the holidays, on the Tuesday between Christmas and New Year’s, when you have the smallest possible audience? The topic is far too important to raise when no one is listening. Just ask Mr. Feight, who says Aug. 24 “will live in my mind forever.”

Let’s hope regulators take that day as seriously as he does.