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Unintended consequences being studied as safeguards put in place after 2010 may not have anticipated the speedy evolution of investment vehicles. The turnover figures and a graph showing the movement of the Hang Seng Index is displayed on a screen at a securities brokerage in Hong Kong, China, on Monday, Aug. 24, 2015.

Jerome Favre/Bloomberg

Five years ago a "flash crash" wiped out $1-trillion (U.S.) in paper wealth in a 20-minute stock free fall. When markets sank with similar speed last week, the rules put in place to prevent a recurrence of that episode faced their first major test. The results were mixed and now regulators are reviewing the safeguards designed to restore order to erratic markets.

Last week's drama began the moment the opening bells rang in New York and Toronto on Aug. 24. A steep descent in stock prices minutes into the sell-off triggered a series of circuit breakers, halting trading on hundreds of securities.

But in what seems to have been an unintended consequence of those trading interruptions was what happened to several exchange-traded funds that day. These funds have soared in popularity since 2010 because they track a basket of shares and give retail investors a low-cost opportunity to access previously inaccessible asset classes. When stocks were halted on Aug. 24, the result caused mayhem for many large ETFs because they became unmoored from their underlying share prices. The result was exaggerated swings in ETF prices, in excess of 40 per cent in some cases.

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"This was a thousand different flash crashes," said Jurrien Timmer, director of global macro at Fidelity Investments.

That lost value was mostly quickly recovered as markets bounced back from the brief collapse of sentiment, but investors acting on panic were susceptible to deep losses.

ETFs are claiming an ever-growing share of trading in the United States and Canada. The U.S. markets now have more than 1,600 listed ETFs valued at more than $2.1-trillion, up from $826-billion just five years ago, according to fund researchers Lipper. The Canadian ETF space now numbers more than 500 funds, with a total value of about $100-billion (Canadian), according to data provided by Morningstar.

But some say ETFs are vulnerable to the kind of flare-up in volatility recently experienced and that has raised concerns about the performance of these instruments through a sustained market event.

This week, securities officials said they were considering changes to the measures meant to control extreme volatility. "Everything is on the table," said Steve Crutchfield, head of exchange-traded products at the New York Stock Exchange. In Canada, the Investment Industry Regulatory Organization of Canada recently produced new guidance on stock price thresholds to reduce unexplained volatility. The new guidance is designed to prevent orders from being executed at prices more than 10 per cent  different from market prices on ETFs and actively traded stocks.

That Monday morning was awash in pessimism well before trading began in North America. Over the weekend, concerns built up over discouraging Chinese economic indicators. After the Shanghai Composite index fell by 8.5 per cent, U.S. stock futures were warning of steep losses at the open. China's "Black Monday" appeared to be spreading to U.S. stocks.

In response, the New York Stock Exchange invoked what it calls Rule 48 to try to stifle the approaching panic.

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In the normal course of events, the opening bid and ask prices are announced each trading day by so-called "market makers," which are broker-dealers tasked with facilitating trade in each listed security.

In instances when volatile markets are likely to impair the ability of market makers to manage an orderly opening, Rule 48 allows them to refrain from posting opening quotes.

While it's designed to help pacify wild markets, Rule 48 may have made matters worse.

"That bit of information was missing that morning for individual equities, and ultimately the ripple effect was felt and magnified in terms of what you saw with ETF prices," said Ben Johnson, director of global ETF research at Morningstar.

The dread leading up to trading that day proved justified. It took only six minutes for the Dow Jones industrial average to post its largest drop in history – nearly 1,110 points.

Giants of the U.S. stock market stumbled. Apple, the world's largest stock, fell by 13 per cent at the open.

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Moves of that magnitude set off the second big regulatory safeguard of the day – the limit up-limit down rule – which halts trading on a major stock if it moves by more than various amounts from its most recent price. That base price is typically calculated on a five-minute trailing basis.

"That's a perfectly good threshold if you've got five minutes worth of prices," Mr. Johnson said. "When something like this happens at the market open, it's going to be tripped at whatever the first price was." As a result, stocks gapped down at the onset of trading by startling amounts.

More than 1,250 trading halts were triggered that morning, each lasting for a minimum of five minutes. But many ETFs tracking halted stocks continued to trade, untethered from their underlying value, which required market makers to manually estimate their value.

"In a volatile environment, we make measured assumptions of what we think it's going to be worth," said Tom Gajer, managing director and head of trading at RBC Dominion Securities. "Today's market trades in microseconds – any human reaction requiring judgment, no matter how quick, is centuries by comparison. This means it can take time before we re-enter the market."

Mandatory risk checks require market makers like Mr. Gajer to widen their spreads – raising their ask prices and lowering their bids – to protect against the heightened risk as prices bounce around. In some cases, volatility requires them to pull back from markets entirely.

That results in liquidity drying up in ETFs while sell orders continue to accumulate, putting what can amount to serious downward pressure on individual funds.

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While the S&P 500 index fell by 5.3 per cent at its lowest point, some index ETFs, which are designed to follow that pool of stocks, exhibited far worse losses. The iShares Core S&P 500 ETF, for example, fell by as much as 26 per cent in morning trading. The Guggenheim S&P 500 Equal Weight ETF was down by 43 per cent at its trough. In Canada, the iShares S&P TSX Capped Financials Index Fund fell by as much as 27 per cent from the prior day's close.

The market normalized over the course of about 45 minutes, but investors trading on certain types of orders may have had a very bad day. Market orders are filled at the best available price, which at the height of Monday's frenzy may have triggered sell orders at deeply discounted prices.

While the U.S. Securities and Exchange Commission and stock exchanges themselves may tweak Rule 48 and maybe restrict the limit rules, the structure of today's markets makes similar episodes difficult to rule out, said Larry Berman, co-founder of ETF Capital Management.

"We're going to have a higher degree of these mini flash crashes, and I don't see a way around it," he said. "So you've got to adapt rules to minimize the damage when it's bad."

With a file from Reuters

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