Don’t Call This a Flash Crash!

On Tuesday, January 24, 2023, the New York Stock Exchange (NYSE) had a problem with its opening auction, which caused the price of many stocks—including names such as McDonald’s and Morgan Stanley—to plummet quickly before recovering shortly thereafter. Like many of you, I’ve been trying to better understand the cause of the issue and possible effects of it, especially as the NYSE considers actions for the impacted trades. I’ve repeatedly read phrases describing the event as: “a trading glitch,” “wild price swings,” “system issues” and a “quick plunge.” But I’ve been completely flabbergasted to not come across the phrase “flash crash.”

“Flash crash” are two words that, like “Lord Voldemort,” may send shivers down many spines, particularly for anyone who was part of the ETF ecosystem back in 2010 and 2015. I have discussed the crashes that occurred in those years in some form several times before (also here), mainly to examine how they could happen and what trading strategies could be deployed to avoid them. What was particularly unnerving during those crashes was that, with many of the impacted securities being ETFs, the entire ETF structure was under attack.

Even if no one is calling this the “2023 Flash Crash,” I think that’s exactly what this was. And it happened to some of the most liquid large-capitalization stocks in the United States. With that in mind, here are my two main ETF-related takeaways:

Flash crashes have nothing to do with the structure of ETFs

In the early days of ETF education, I think there was a general misconception that an ETF would always trade in line with the value of its underlying basket of securities, courtesy of ETF arbitrage. While this is usually the case, it is not always the case. During times of extreme market volatility (or a rare market structure event), an ETF can trade more like a single stock, especially when there is uncertainty in the value of the underlying basket of securities. We saw this occur in March 2020 amid growing instability due to the COVID-19 pandemic.

As for the ETF structure, we now have three decades of proof that these transparent and tax-efficient funds work as designed. Hopefully those days of blaming ETF design are behind us and observers will no longer point at an ETF trade that is not trading perfectly in line with the value of its basket as proof of some fundamental flaw in its structure.