A practice referred to as 'operational shorting' could destabilize the broader markets and lead to a contagion effect
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Given the return of market volatility last year and the new highs in the global ETF industry, it may be time to revisit an old debate: whether ETFs can contribute to instability in turbulent markets. Detractors of the exchange-traded vehicles have expressed misgivings since 2011, and new research suggests an even greater cause for concern from a practice used by fund operators.
“[W]hile ETF market makers are required to own the shares that make up the basket of stocks the funds represent, rules allow them to sell shares that they don’t already own … on the presumption that they will purchase those shares later,” explained Wall Street Journal contributor Simon Constable. “Settlements of these trades, however, [do] not always happen quickly.”
The upshot, suggested the authors of a recent working paper titled ETF Short Interest and Failures-to-Deliver: Naked Short-Selling or Operational Shorting?, is that ETF dealers could sometimes make markets without creating new units of the ETF they have sold. The practice, which the authors have dubbed “operational shorting,” is designed to create extra liquidity to the ETF market and reduce market volatility.
But by effectively selling shares they neither own nor have borrowed, the authors suggest, ETF makers run the risk of actually destabilizing the broader markets. When they reviewed failure-to-deliver (FTD) data, which measures how many sold shares were not delivered within the normal window of time, they found 78% of FTDs came from the ETF business in 2016; that was up from 72% in 2015.
“Increases in the overall volume of FTDs might impair some market participants’ ability to meet their other obligations in a timely way, leading to greater counterparty risk,” the research paper said. One negative-case scenario would have a dealer selling shares it doesn’t own, only to incur losses when the market moves the wrong way.
Not everyone is convinced there’s an issue. “The risk is small relative to the size of the product,” Petra Bakosova, chief operating officer of financial firm Hull Tactical Asset Allocation, told the Journal.
ETF dealers are also able to hedge risks at the end of each session, she added, by buying futures or options as needed to offset any possible losses from positions that can go sour. But Rabih Moussawi, professor of finance at Villanova University and one of the paper’s authors, contended that such hedges can be very costly when they’re needed most.
Adding to the risk is the increased role of algorithmic trading in the markets. Such robotic traders, programmed to detect which ETFs and stocks are mispriced relative to each other, can buy or sell as needed to take advantage of arbitrage opportunities.
When markets are stable and bid-ask spreads are tight, the algorithms can continue trading. But “[w] hen the market breaks down, the algos disappear, and then you can get into a free fall or move straight higher because the liquidity disappears,” said Peter Tchir, head of macro strategy at New York-based financial firm Academy Securities.
The authors also suggested a risk from contagion: an ETF dealer that practices operational shorting for one ETF is more likely to do so for other ETFs for which it makes markets, and even more so when it’s in debt. Aside from that, one ETF market maker that engages in such activities could prompt others that trade in the same or similar ETFs to do so.
