The ETF Market Kind Of Broke Yesterday

Yesterday's big selloff exposed a weakness in one of Wall Street's darling products, Exchange Traded Funds (ETFs), the FT reports, and no one really saw it coming.

ETFs are a baskets of goods that can be traded like a single asset. They've become really popular on the Street over the last decade to the point where you can buy an ETF of almost anything — gold, kinds of companies, groups of countries (like emerging markets)... the list goes on.

And just like everything else, they got killed yesterday (the list below is just a small sampling).

The problem wasn't just that ETFs got swept up in the general panic of the moment. It was that as traders sold off and ETFs got cheaper, the discount between the price of the ETF and the assets that made it up widened.

Suddenly, everyone wanted to redeem those underlying assets from banks like Citi and State Street.

Now you can imagine what happened next (from FT):

One Citi trader emailed other market participants to say: "We are unable to take any more redemptions today?.?.?.?a very rare occurrence due to capital requirements we are maxed out on the amount of collateral we have out."

A person familiar with the situation said it was a temporary suspension affecting only some clients, caused by the significant amount of sell orders. Citi declined to comment.

State Street said it would stop accepting cash redemption orders for municipal bond products from dealers.

In short, people couldn't get their money, and there is fear that this selloff will continue.

While all of this was unexpected, it wasn't necessarily unheard of. In 2010, the Kauffman Foundation put out a report saying that ETFs were more dangerous than even high frequency trading (this was in the aftermath of the Flash Crash) and cause a flash crash themselves.

Specifically, Kauffman said that the problem with ETFs was that they end up driving the price of the underlying assets that make them up. The actual value of the asset ceases to matter as the activity of the ETF takes it over.

That, Kauffman said, could cause what we saw yesterday — "failure to settle" (market participants freaking completely out because they can't get their money).

Investors are starting to talk about this too. It's usually just a quick comment here or there about how, in the future, the most taxing job of a Wall Street analyst may be to get under the hood of an ETF and see what's really going on in there.

This is one to watch.

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