Can ETFs collapse? No!
Can ETFs collapse? No!
A few weeks ago a blog posted a white paper that suggested ETFs can collapse. They suggested that the popularity of ETFs is undeniable; they are bought by investors as low cost and liquid vehicles to buy whole indices in a single trade. Hedge funds short them to mitigate risks (neutralize beta), with a single trade rather than shorting 500 stocks. It is a lucrative market for the issuers, authorized participants and brokers. Currently there is over $1 trillion globally with about 2200 ETFs (4000+ listings).
The Issue: Short selling of ETFs
There is explosive short interest in some ETFs where owners of ETF shares often far outnumber the actual issued. The example used was of the SPYDER S&P Retail ETF (NYSE: XRT) with nearly 95 million holders at the end of June while the outstanding shares of the ETF were just 17 million. How can this happen? Short sellers borrow a long position and sell it into the market. The purchaser is unaware his ETF shares were purchased from a short-seller. The author's contention is this clearly creates a serious counterparty risk insufficient to meet redemptions. The author clearly does not understand the mechanics of short selling.
Mechanics of short selling
First, the shares must be "located" from a lender. Then they enter into a lending agreement to borrow the shares from a long holder. The short seller can sell the shares in the market with the caveat that the shares can be recalled at any time. Now there are two owners of the same shares. This can continue so you can see how the number of holders can grow. This is no different than it is for stocks. If the shares are recalled, it forces the short to find new shares to borrow or cover short. The author contends this is naked shorting—it is not. Naked short selling is selling short without a locate or a borrow; it is a violation of regulation SHO, which mandates short sellers need to borrow.
The ETF creation/redemption process
If the authors read any ETF prospectus, they would have found that authorized participants, mostly large brokerages self-clearing members (DTCC), are governed by rules to interact with the ETF trust. ETF trusts have provisions to protect from a run on the trust. APs can only redeem with settled shares; this means they must have the shares in their possession. This requires shares to be released from stock lending agreement. There are also limits in many cases. APs are typically limited (25%) redeem of entire shares outstanding in any single transaction. AP must verify that the shares are in their possession, which means a short must be covered before underlying shares are released. So while this caused some media grabbing headlines without vetting the information, the paper is clearly misleading and inaccurate. This response is a compilation of responses from several Canadian and U.S. ETF providers.
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