Regulators worried about opacity and volatility in exchange-traded funds are.  So, beginning in 2018, these funds will be required to identify which Wall Street brokers or market-makers, they rely on to smooth trading in the securities.

The disclosures, enacted in October, are among the first specific changes to emerge from the broad SEC review of ETF trading and complexity that has been conducted, off and on, since 2011.  Concerns have grown since then as more complex funds have been launched and ETFs have sometimes endured huge price swings.

“They are being very honest about it—they don’t understand how ETFs work and how they are impacted” by stressed markets. - John McGuire of Morgan, Lewis.

On 8/24/15, ETF prices nose-dived, triggering trade halts that made it harder for shares to rebound and caused some investors to lock in losses. The SEC is still examining the circumstances around that date and other bouts of market turmoil and plans in the next several weeks to issue an analysis of whether disruptive trading practices worsened volatility, the people said. 

“August of 2015 was totally unexpected and the SEC doesn’t like to be taken by surprise,” Mr. McGuire said.

Several stock exchanges have already amended trading rules in response to the mayhem of 8/24/15, in order to reduce the number of trade halts that ETFs experience and allow prices more room to vary during periods of market stress.

Because ETF shares are traded on exchanges, with constant buying and selling, an ETF’s market price can veer from the fair value of its assets. When that happens, investors buying or selling ETFs can get shortchanged. That is why regulators and fund sponsors rely on middlemen such as Goldman Sachs or Morgan Stanley to step in by supplying or removing ETF shares from the market, which forces prices back in line with the fund’s underlying assets.

The specialized market makers have a financial incentive to intervene. When ETF shares trade at a premium to the fund’s assets, brokers can earn nearly risk-free profits by purchasing the less expensive holdings and exchanging them for higher-priced ETF shares. They benefit by trading in the opposite direction when ETFs sell at a discount to the fund’s assets.

The concern for some regulators, including SEC Commissioner Kara Stein, is that ETFs may not have a sufficient number of middlemen to ensure steady trading and fair pricing – even during times of extreme volatility. Citigroup, one such ETF market maker, temporarily stopped redeeming some ETF shares in June 2013 amid a selloff in emerging-market stocks. The bank said it suspended activity after selling fervor caused it to hit self-imposed risk limits.

However, BlackRock and others who offer ETFs say those concerns are overblown.