Flash Surge in World’s Biggest ETF Linked to ‘Outlandish’ Trades

(Bloomberg) -- At 1:25 p.m. in New York on Monday, something unusual happened to the world’s largest exchange-traded fund.

After opening at $364.97 per share and straying less than 0.9% in either direction for almost four hours of trading, the price suddenly rocketed.

The SPDR S&P 500 ETF Trust (SPY) shot to $378.46, the highest level it has ever reached. More than 150,000 trades were executed at $370 or above, totaling almost $58 million. Then, just as suddenly, the price dropped back to about $367.50.

The whole thing took less than one second.

For any investor checking their portfolio at the end of the day or week, or even a trader out at lunch, it may as well never have happened. But for Wall Street worrywarts it’s a reminder of one of the lurking dangers in these ultra-fast modern markets.

The trades behind SPY’s spike were what is known as intermarket sweep orders, or ISOs. In very simple terms, they are automated trades that “sweep” the market picking up as many shares as possible at the best price available.

Ordinarily, regulations dictate that any stock order must be filled at the best possible price anywhere in the market. But ISOs are effectively an exception, and the upshot is that one trading venue can wind up filling an entire order, regardless if there are better prices elsewhere. When liquidity is low or ISOs are being used aggressively, it raises the possibility they can rapidly consume the better-priced shares at a single exchange and keep going -- paying more and more to fill the order.

“The ISO is pretty much the only way to blow out the book in that manner,” said Steve Sosnick, chief strategist at Interactive Brokers, referring to the SPY surge. “The lighter liquidity may have enabled a larger move. If fewer traders are lining the book with orders there is less to keep an outlandish order in line. That leads to greater market impact.”

‘Fat Finger’

On Monday about 96 million shares of SPY changed hands. While that is below the average daily trading volume of almost 102 million shares in the year through Friday, it’s by no means terrible, leading Sosnick and other observers to conclude the spike was more likely human error rather than a structural glitch.

Dave Nadig, chief investment officer and director of research at research and data provider ETF Flows, reckons someone at a big institution made a mistake when the ISO was placed.

“Most likely, someone intended to put a limit on it, and didn’t,” he said. “I cannot begin to tell you why someone would put that order in. It, to me, reeks of a fat finger, not an intentional trade.”

The action all took place at 1:25 p.m. and 27 seconds precisely. A second before, there were a handful of trades in SPY -- not enough to fill one screen of Bloomberg’s Quote Recap function -- all but one at $367.44 per share. In the following second, the number of transactions surged. All told they fill almost 66 screens and about 85% of them are marked as ISOs. The data show that all of the more expensive trades were routed through the NYSE Arca Exchange, SPY’s primary listing.

A spokesperson for NYSE Arca declined to comment.

At State Street, Matt Bartolini said moves like this illustrate why executing market orders right is so vital.

“That’s such a big part of lowering your total cost of ownership,” said the head of SPDR Americas Research. “Your bid-ask spread might be a basis point, but you could have dislocations relative to fair market value and that’s market impact. That’s an implicit cost that you can only know after the trade.”

A potential X-factor to all this is the timing: The spike occurred on Tesla Inc.’s first day as a member of the S&P 500.

It’s not immediately clear whether or how that could connect to the ISO trades and mini surge, but the benchmark U.S. gauge has never had to absorb such a large company. The investing world has been on alert for unintended side effects.

Aggressive Use

In the case of SPY on Monday, the ISO was a buy order so the price shot up, but the process can also work in the other direction. As early as 2012, there was evidence connecting ISOs to incidences of mini flash crashes.

Academics at the University of Manchester’s Business School and School of Computer Science studied multiple incidents in the U.S. equity market in the five years through 2011. They found that “aggressive use” of ISOs in a fragmented market was fueling sudden declines.

Their paper classified 3,488 crashes, or almost 68% of the total, as ISO-initiated, and went as far as suggesting the trades should be banned.

While SPY seems to have suffered no ill-effects from this week’s spike, it may have been a bruising experience for whoever was behind the trades.

For other investors, it’s a lesson that even the most liquid vehicles aren’t immune from shocks, according to Eric Balchunas, an ETF analyst at Bloomberg Intelligence.

“We have always put SPY in a group of about 15 ETFs that were able to digest market orders with no worries,” he said. “This was a good reminder that nothing is truly 100% safe from a market order gone bad.”

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With assistance from Bloomberg