Exchange-Traded Funds, Market Structure and the Flash Crash

The “Flash Crash” of May 6, 2010 saw some stocks and exchange-traded funds traded at pennies only to rapidly recover in price. We show that the impact of the Flash Crash across stocks is systematically related to prior market fragmentation. Interestingly, fragmentation measured based on quote competition – reflective of higher frequency activity – has explanatory power beyond a more standard volume-based definition. Using intraday trade data from January 1994-September 2011, we find that fragmentation now is at the highest level recorded. We also show divergent intraday behavior of trade and quote fragmentation on the day of the Flash Crash itself. The link to higher frequency quotation activity and the current high levels of fragmentation help explain why a Flash Crash did not occur before and offers a counterpoint to the view that the Flash Crash stemmed from an unlikely confluence of events. Controlling for fragmentation, exchange-traded products were differentially affected reflecting the difficulty in pricing component securities. Market structure reforms enacted since the Flash Crash should help mitigate future such market disruptions, but have not eliminated the possibility that another Flash Crash would occur, albeit with a different catalyst and perhaps in a different asset class