Below is a comment submitted to the SEC in May 2008, which suggests addressing the enormous settlement failures in the ETF Market.
(emphasis mine) [my comment]
James J. Angel, Ph.D., CFA
Associate Professor of Finance
Room G4 Old North
Washington DC 20057
1 (202) 687-3765
May 16, 2008
Ms. Nancy M. Morris, Secretary
Securities and Exchange Commission
100 F St. NW Washington, DC 20549-9303
Release Nos. 33-8901; IC-28193; File No. S7-07-08
Dear Ms. Morris:
Here are my comments on the proposed rule to reduce regulatory burdens on the issuance of ETFs. In general, the proposal to simplify the process for issuing ETFs is a great step forward and such reform is long overdue. However, there is a serious problem in the ETF market that the Commission should address as it standardizes procedures for creating new ETFs. The large and protracted settlement failures in the trading of ETFs indicate that there is something wrong, either in the design of the ETF product or in the structure of secondary market trading.
The Commission should address the enormous settlement failures in the ETF Market.
When a seller fails to deliver a security on the normal settlement date, an owner of the security is effectively forced into making an involuntary stock loan to the seller [Nice way of explaining it]. This violates one of the basic property rights of an owner, the ability to exclude others from the use of the property. In addition, it may deprive the buyer of the ability to earn stock lending revenue, as well as voting rights. The buyer may even have to pay higher tax rates on substitute dividend payments, which are taxed differently than normal dividends.
In response to numerous complaints, the Commission adopted Regulation SHO to reduce settlement failures. Under Regulation SHO, the Commission mandates special rules for securities in which failures to deliver exceed a certain "threshold" of size and length of failure.
As of this writing, over 100 ETFs and ETNs are on the Regulation SHO Threshold List.1 These settlement failures affect some of the largest ETFs as well as the smallest. For example, the iShares Russell 2000 Index (IWM) experienced over 30 trading days in the year 2007 in which over 10 million shares failed. These failures were for over $1 billion worth of shares each day. Similarly, the original SPDR Trust (SPY) experienced at least 10 trading days in 2007 with settlement failures of over a billion dollars per day.
Inclusion on the Regulation SHO Threshold List often makes it hard for investors, particularly retail investors, to engage in short sales. Many brokers will not take the effort to locate shares in order to execute short transactions in Threshold stocks. I have been personally told by my broker that shares were unavailable for shorting some ETFs on the Threshold List. Ease of short selling is one of the attractive features of ETFs, and thus the large settlement failures diminish one of the important features of this important product class.
Settlement failures may affect the market quality for ETFs.
Barriers to short selling may impact the pricing quality of the ETF, leading to more pricing errors relative to the underlying Net Asset Value (NAV) and wider bid-ask spreads. As the Commission itself notes on page 36 of the proposing release, "Impeding the ability of arbitrageurs to purchase and redeem ETF shares could disrupt the arbitrage pricing discipline, which could lead to more frequent occurrences of pricing premiums or discounts." For this reason, the Commission should work towards efficient methods for reducing settlement failures in ETFs.
It is not clear why there are so many settlement failures in ETFs [probably widespread naked short selling]. Theoretically, anyone can create an ETF by presenting a creation unit sized block of the underlying shares (or sometimes the cash equivalent) to the sponsor of the ETF. Thus, there should never be failures larger than a creation unit in an ETF. Yet, casual inspection of the failure to deliver data released by the Commission indicates many instances of failures to deliver ETFs in the millions of shares.
Perhaps one reason is the fear of being deemed an underwriter, as mentioned in Note 22. The Commission may wish to establish a safe harbor in the rule so that normal arbitrage activity will not trigger this problem, even when other affiliates of a firm are recommending the securities.
The appendix to this comment letter displays a partial list of the ETFs and ETNs on the list as of May 14, 2008. Also, I have attached a set of references to my other comment letters on short selling and settlement failures.
Smaller creation unit sizes may lead to fewer settlement failures.
The Commission requests comment on the size regulations for creation units. Given that larger creation unit sizes may make it harder for arbitrageurs to create shares to deliver against their short positions, it makes sense that reducing creation unit sizes may make it easier for arbitrageurs to deliver shares instead of failing. [Agreed, but this will do nothing to solve the problem of naked short selling]
Smaller creation unit sizes may lead to smaller tracking errors.
Although the larger ETFs track their underlying indices closely, some of the smaller ETFs experience larger tracking errors. Reducing the size of creation units may reduce transactions costs faced by arbitrageurs, thus creating more incentives for arbitrage to keep tracking errors small.
The Commission should let the issuers set creation unit sizes and fees.
I recommend setting the minimum creation unit rather small, and letting the market sort out what the most efficient size is. Sponsors of ETFs have a strong financial incentive to set the creation unit size and transactions fees at the profit maximizing level, which generally means at the asset maximizing level. Since investors will prefer ETFs with smaller spreads and lower tracking error, this means that the economic incentive is to create the most liquid ETF possible.
Given that the sponsors have the proper economic incentives to promote liquid ETFs, I don't think the Commission needs to worry about setting the size of creation units or imposing requirements on boards to worry about this. Putting an explicit requirement into the rule just adds to the compliance costs as the lawyers and regulators will have one more unnecessary box to check off in their inspections.
Creation unit size thresholds for exemptions in disclosure requirements should be set at 1,000 shares.
The proposals in the rule to provide various exemptions from disclosure for funds with creation unit sizes greater than 25,000 shares will create a de facto minimum of 25,000 shares. The Commission fears that a smaller creation unit size will lead to retail investors transacting too often directly with the fund company. Given that most retail trades are a few hundred shares at most, the Commission could safely set the threshold for disclosure exemption at 1,000 shares.
[The US currently has no requirement for disclosure of short positions (disclosure requirements for long positions over 5%), so lowering the disclosure exemption is that big a deal in terms of naked short selling (short positions won't be disclosed in either case).]
James J. Angel
McDonough School of Business
Washington DC 20057
Previous comment letters by James Angel, Georgetown University, on Regulation SHO:
Comment on short selling in a public offering: http://www.sec.gov/comments/s7-20-06/s72006-7.pdf
Partial list of ETFs and ETNs on the Regulation SHO Threshold List on May 14, 2008 [Key word here is "partial"]
Barclays Bank PLC iPath Exchange Traded Notes Linked to Goldman Sachs Crude Oil Total Return Index
Barclays GEMS Index ETN
BearLinx Alerian MLP Select Index ETN
BlackRock New Jersey Municipal Bond Trust
BRoad InDex Guarded Equity-linked Securities (Bridges) based on the value of S&P Midcap
BRoad InDex Guarded Equity-linked Securities (BRIDGES) Based on the value of the S&P 500
Claymore MAC Global Solar Energy Index ETF
Claymore/AlphaShares China Small Cap Index ETF
Claymore/Sabrient Insider ETF
Currencyshares Australian Dollar Trust
CurrencyShares Euro Trust
Deutsche Bank Gold Double Short ETN
First Trust Amex Biotechnology Index Fund
First Trust Consumer Discretionary AlphaDEX Fund
First Trust Energy AlphaDEX Fund
First Trust FTSE EPRA/NAREIT Global Real Estate Index Fund
First Trust IPOX-100 Index Fund
First Trust S&P REIT Index Fund
First Trust Small Cap Core AlphaDEX Fund
iPath Dow Jones -AIG Livestock Total Return Sub-Index ETN
iPath Dow Jones -AIG Industrial Metals Total Return Sub-Index ETN
iPath ETNs Linked to the MSCI India Total Return Index
iPath Exchange Traded Notes LInked to the CBOE S&P 500 BuyWrite Index
iPath Optimized Currency Carry ETN
iShares DJ US Real Estate
iShares Dow Jones U.S. Broker-Dealers Index Fund
iShares FTSE/Xinhua China
iShares iBoxx $ High Yield Corporate Bond Fund
iShares JP Morgan USD Emerging Markets Bond Fund
iShares Lehman Government/Credit Bond Fund
iShares Lehman Intemediate Credit Bond Fund
iShares Morningstar Small Value
iShares MSCI Brazil IX
iShares MSCI BRIC Index Fund
iShares MSCI Chile Index Fund
iShares MSCI EAFE Growth Index Fund
iShares MSCI Israel Capped Investable Market Index Fund
iShares MSCI Spain Index
iShares MSCI Spain Index
iShares MSCI Turkey Investable Market Index Fund
iShares S&P California Municipal Bond Fund
iShares S&P Global Financials Sector Index Fund
iShares S&P Global Infrastructure Index Fund
iShares S&P New York Municipal Bond Fund
iShares S&P U.S. Preferred Stock Index Fund
iShares S+P Asia 50 Index Fund
KBW Insurance ETF
MACROshares Oil Down Tradeable Shares
Market Vectors -Steel ETF
PowerShares 1-30 Laddered Treasury Portfolio
PowerShares Active Alpha Multi-Cap Fund
PowerShares Cleantech Portfolio
PowerShares DB Energy Fund
PowerShares DB Oil Fund
PowerShares DB Precious Metals Fund
PowerShares DWA Emerging Markets Technical Leaders Portfolio
PowerShares Dynamic Deep Value Portfolio
PowerShares Dynamic Energy Exploration & Production Portfolio
PowerShares Dynamic Industrials Sector Portfolio
PowerShares Dynamic Leisure & Entertainment Portfolio
PowerShares Dynamic Mid Cap Portfolio
PowerShares Dynamic Retail Portfolio
PowerShares Dynamic Technology Sector Portfolio
PowerShares Dynamic Telecom & Wireless Portfolio
PowerShares Emerging Markets Sovereign Debt Portfolio
PowerShares FTSE RAFI Emerging Markets Portfolio
PowerShares Global Clean Energy Portfolio
PowerShares Global Nuclear Energy Portfolio
PowerShares Golden Dragon Halter USX China Portfolio
PowerShares India Portfolio
PowerShares International Listed Private Equity Portfolio
PowerShares Listed Private Equity Portfolio
PowerShares Preferred Portfolio
Rydex Inverse 2x Russell 2000 ETF
Rydex Inverse 2x S&P 500 ETF
Rydex Inverse 2x S&P MidCap 400 ETF
Select Sector SPDR-Consumer Discretionary
Short MSCI Emerging Markets ProShares
Short QQQ ProShares
SPDR Homebuilders ETF
SPDR MSCI ACWI ex-US ETF
SPDR S&P China ETF
SPDR S&P Emerging Asia Pacific ETF
SPDR S&P Emerging Europe ETF
SPDR S&P Emerging Latin America ETF
SPDR S&P Emerging Markets ETF
SPDR S&P Emerging Middle East & Africa ETF
SPDR S&P Metals & Mining ETF
SPDR S&P Retail ETF
Stock Market Upturn Notes Based Upon a U.S.-Europe-Japan Basket
Ultra Industrials ProShares
Ultra Russell MidCap Growth ProShares
Ultra Russell1000 Growth ProShares
Ultra Russell2000 Growth ProShares
UltraShort Basic Materials ProShares
UltraShort FTSE/Xinhua China 25 ProShares
UltraShort Industrials ProShares
UltraShort MSCI Emerging Markets ProShares
UltraShort Semiconductors ProShares
Vanguard Europe Pacific ETF
Vanguard FTSE All-World ex-US ETF
Vanguard Intermediate-Term Bond ETF
Wisdom Tree Emerging Market High-Yielding Equity Fund
WisdomTree Earnings 500 Fund
WisdomTree India Earnings Fund ETF
WisdomTree International Financial Sector Fund
WisdomTree International Health Care Fund
WisdomTree SmallCap Dividend Fund
My reaction: As I suspected, there are enormous settlement failures in the ETF Market.
1) There are large and protracted settlement failures in the trading of ETFs.
2) When a seller fails to deliver a security on the normal settlement date, an owner of the security is effectively forced into making an involuntary stock loan to the seller.
3) settlement failures violate the basic property rights of an owner and deprive the buyer of the ability to earn stock lending revenue.
4) On May 16, 2008, over 100 ETFs and ETNs were on the Regulation SHO Threshold (failures to deliver for these ETFs/ETNs exceeded a certain "threshold" of size and length of failure).
5) Theoretically, there should never be failures larger than a creation unit in an ETF, because anyone can create new share of an ETF by presenting a creation unit sized block of the underlying assets to the sponsor of the ETF.
6) Despite this, instances of failures to deliver ETFs in the millions of shares are common.
Conclusion: naked short selling is happening in ETFs and it is probably an even greater problem than it is in stocks. This is because the total amount of shares in the market for ETFs is constantly changing, which obscures naked short selling.
Stay away from ETFs, especially gold/silver ETFs based in the US (GLD/SLV).