Enormous Settlement Failures In The ETF Market

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
Georgetown University
Room G4 Old North
Washington DC 20057

angelj@georgetown.edu
1 (202) 687-3765

May 16, 2008

Ms. Nancy M. Morris, Secretary
Securities and Exchange Commission
100 F St. NW Washington, DC 20549-9303

Rule-comments@sec.gov

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).]


Respectfully submitted,

James J. Angel
Georgetown University
McDonough School of Business
Washington DC 20057

(202) 687-3765

References

Previous comment letters by James Angel, Georgetown University, on Regulation SHO:

http://www.sec.gov/comments/s7-19-07/s71907-117.pdf
http://www.sec.gov/comments/s7-12-06/s71206-266.pdf
http://www.sec.gov/comments/s7-21-06/s72106-35.pdf
http://www.sec.gov/rules/proposed/s72303/jjangel011004.htm


Comment on short selling in a public offering: http://www.sec.gov/comments/s7-20-06/s72006-7.pdf

Appendix One:
Partial list of ETFs and ETNs on the Regulation SHO Threshold List on May 14, 2008
[Key word here is "partial"]

Symbol

Security Name

OIL

Barclays Bank PLC iPath Exchange Traded Notes Linked to Goldman Sachs Crude Oil Total Return Index

JEM

Barclays GEMS Index ETN

BSR

BearLinx Alerian MLP Select Index ETN

BLJ

BlackRock New Jersey Municipal Bond Trust

BRoad InDex Guarded Equity-linked Securities (Bridges) based on the value of S&P Midcap

MCB

400 Index

BRoad InDex Guarded Equity-linked Securities (BRIDGES) Based on the value of the S&P 500

BRD

Index

TAN

Claymore MAC Global Solar Energy Index ETF

HAO

Claymore/AlphaShares China Small Cap Index ETF

NFO

Claymore/Sabrient Insider ETF

FXA

Currencyshares Australian Dollar Trust

FXE

CurrencyShares Euro Trust

DZZ

Deutsche Bank Gold Double Short ETN

FBT

First Trust Amex Biotechnology Index Fund

FXD

First Trust Consumer Discretionary AlphaDEX Fund

FXN

First Trust Energy AlphaDEX Fund

FFR

First Trust FTSE EPRA/NAREIT Global Real Estate Index Fund

FPX

First Trust IPOX-100 Index Fund

FRI

First Trust S&P REIT Index Fund

FYX

First Trust Small Cap Core AlphaDEX Fund

COW

iPath Dow Jones -AIG Livestock Total Return Sub-Index ETN

JJM

iPath Dow Jones -AIG Industrial Metals Total Return Sub-Index ETN

INP

iPath ETNs Linked to the MSCI India Total Return Index

BWV

iPath Exchange Traded Notes LInked to the CBOE S&P 500 BuyWrite Index

ICI

iPath Optimized Currency Carry ETN

IYR

iShares DJ US Real Estate

IAI

iShares Dow Jones U.S. Broker-Dealers Index Fund

FXI

iShares FTSE/Xinhua China

HYG

iShares iBoxx $ High Yield Corporate Bond Fund

EMB

iShares JP Morgan USD Emerging Markets Bond Fund

GBF

iShares Lehman Government/Credit Bond Fund

CIU

iShares Lehman Intemediate Credit Bond Fund

JKL

iShares Morningstar Small Value

EWZ

iShares MSCI Brazil IX

BKF

iShares MSCI BRIC Index Fund

ECH

iShares MSCI Chile Index Fund

EFG

iShares MSCI EAFE Growth Index Fund

EIS

iShares MSCI Israel Capped Investable Market Index Fund

EPP

iShares MSCI Spain Index

EWP

iShares MSCI Spain Index

TUR

iShares MSCI Turkey Investable Market Index Fund

CMF

iShares S&P California Municipal Bond Fund

IXG

iShares S&P Global Financials Sector Index Fund

IGF

iShares S&P Global Infrastructure Index Fund

NYF

iShares S&P New York Municipal Bond Fund

PFF

iShares S&P U.S. Preferred Stock Index Fund

AIA

iShares S+P Asia 50 Index Fund

KIE

KBW Insurance ETF

DCR

MACROshares Oil Down Tradeable Shares

SLX

Market Vectors -Steel ETF

PLW

PowerShares 1-30 Laddered Treasury Portfolio

PQZ

PowerShares Active Alpha Multi-Cap Fund

PZD

PowerShares Cleantech Portfolio

DBE

PowerShares DB Energy Fund

DBO

PowerShares DB Oil Fund

DBP

PowerShares DB Precious Metals Fund

PIE

PowerShares DWA Emerging Markets Technical Leaders Portfolio

PVM

PowerShares Dynamic Deep Value Portfolio

PXE

PowerShares Dynamic Energy Exploration & Production Portfolio

PRN

PowerShares Dynamic Industrials Sector Portfolio

PEJ

PowerShares Dynamic Leisure & Entertainment Portfolio

PJG

PowerShares Dynamic Mid Cap Portfolio

PMR

PowerShares Dynamic Retail Portfolio

PTF

PowerShares Dynamic Technology Sector Portfolio

PTE

PowerShares Dynamic Telecom & Wireless Portfolio

PCY

PowerShares Emerging Markets Sovereign Debt Portfolio

PXH

PowerShares FTSE RAFI Emerging Markets Portfolio

PBD

PowerShares Global Clean Energy Portfolio

PKN

PowerShares Global Nuclear Energy Portfolio

PGJ

PowerShares Golden Dragon Halter USX China Portfolio

PIN

PowerShares India Portfolio

PFP

PowerShares International Listed Private Equity Portfolio

PSP

PowerShares Listed Private Equity Portfolio

PGX

PowerShares Preferred Portfolio

RRZ

Rydex Inverse 2x Russell 2000 ETF

RSW

Rydex Inverse 2x S&P 500 ETF

RMS

Rydex Inverse 2x S&P MidCap 400 ETF

XLY

Select Sector SPDR-Consumer Discretionary

EUM

Short MSCI Emerging Markets ProShares

PSQ

Short QQQ ProShares

XHB

SPDR Homebuilders ETF

CWI

SPDR MSCI ACWI ex-US ETF

GXC

SPDR S&P China ETF

GMF

SPDR S&P Emerging Asia Pacific ETF

GUR

SPDR S&P Emerging Europe ETF

GML

SPDR S&P Emerging Latin America ETF

GMM

SPDR S&P Emerging Markets ETF

GAF

SPDR S&P Emerging Middle East & Africa ETF

XME

SPDR S&P Metals & Mining ETF

XRT

SPDR S&P Retail ETF

SJP

Stock Market Upturn Notes Based Upon a U.S.-Europe-Japan Basket

UXI

Ultra Industrials ProShares

UKW

Ultra Russell MidCap Growth ProShares

UKF

Ultra Russell1000 Growth ProShares

UKK

Ultra Russell2000 Growth ProShares

SMN

UltraShort Basic Materials ProShares

FXP

UltraShort FTSE/Xinhua China 25 ProShares

SIJ

UltraShort Industrials ProShares

EEV

UltraShort MSCI Emerging Markets ProShares

SSG

UltraShort Semiconductors ProShares

VEA

Vanguard Europe Pacific ETF

VEU

Vanguard FTSE All-World ex-US ETF

BIV

Vanguard Intermediate-Term Bond ETF

DEM

Wisdom Tree Emerging Market High-Yielding Equity Fund

EPS

WisdomTree Earnings 500 Fund

EPI

WisdomTree India Earnings Fund ETF

DRF

WisdomTree International Financial Sector Fund

DBR

WisdomTree International Health Care Fund

DES

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).

This entry was posted in Background_Info, Financial_Wizardry, Market_Skepticism, Wall_Street_Meltdown. Bookmark the permalink.

12 Responses to Enormous Settlement Failures In The ETF Market

  1. dashxdr says:

    Crap. I have some FXI because I want to be in China when the currency skew gets corrected (dollar down, Yuan up). Can't trust anything these days.

    Eric can you check the comments on your post, "Exploding Monetary Base And Paying Interest On Excess Reserves"? Your insight is needed!

  2. Anonymous says:

    First of all, thx for the excellent work.
    One additional idea I would like to add to your conclusion 'stay away from GLD and SLV' is to buy physical gold and silver instead ;-)

  3. Anonymous says:

    Excellent job, thanks!

    How do we know if the stocks we have purchased are settled successfully? Please advise if someone knows how. I use Scottrade.

    Jimmy

  4. VegasBD says:

    Eric-

    Thanx again for the good info, even when you are 10,000 miles from home.

    I gave up on GLD and SLV a while ago, and now have a closet full of silver. The premium I had to pay to get it in hand is nothing compared to the lack of worry I now feel when I read all the posts about this stuff from you, Mish and ZH

  5. Anonymous said...
    How do we know if the stocks we have purchased are settled successfully?

    That is the problem, it is not possible to know because there is no transparency in the US settlement process.

  6. Anonymous says:

    Eric and everyone,

    It seems to me that the only alternatives to avoid security fraud are to avoid any security purchase(and keep all savings in PM) and/or to open an account in another country wuth good security regulations. Is Canada good enough? Because Canada is so close to us.

    Any comment?

    Jimmy

  7. Robert says:

    Even if the trades do settle successfully they may get lent out again later and fail to be delivered back again.

  8. Robert said...
    Even if the trades do settle successfully they may get lent out again later and fail to be delivered back again.

    Correct. Wall Street brokers are critically short on cash and will lend out any securities they can to generate cash flow.

  9. Anonymous says:

    Eric and Robert,

    Is there anyway avoiding Wall Street fraud by opening a brokerage account in another country, like Canada or Europe?

    Thanks,

    Jimmy

  10. Jimdownunder says:

    Why aren't "settlement failures in the trading of ETFs" called defaults? This would trigger both exposure of the defaulting broker/seller and the right to sue for liquidated damages. Once all buyers/brokers know who these parties are no-one would buy from them.

    Are ETF markets informed of the identities of defaulting sellers? If not, why not? If there is some rule preventing a free and informed market surely it must be invalid.

  11. Anonymous says:

    I recently read that most securities, even if successfully settled, were held in trust accounts by the Securities clearing house in NY which is owned by the FED.

  12. Robert says:

    Eric;

    This raises again a serious but under-reported issue - how can anyone prepare effectively for catastrophe - whether its a banking meltdown, dollar hyperinflation, national bankruptcy or just plain old inflation.

    I've worked overseas for 16 years now and called every bank imaginable to open a Chinese Yuan fixed-deposit account.

    The closest I got was HSBC who were happy to open accounts in Singapore etc. for non-residents - but not in Yuan. You have to be a resident of Hong Kong to open the Yuan acct.

    So naturally the last place to look would be some currency traders (who's background exposure to these ETF problems would never be obvious).

    So instead I've just returned from Abu Dhabi to open a Dhiram & Saudi Riyal accounts - hoping they'll break the dollar peg when it goes down the toilet - preserving some of my hard earned wealth.

    And as for gold - well there's a bunch of issues there too:

    1: I'm in the school of thought that says the US WILL confiscate gold bullion accounts. I feel that the reduced scope of the US gov't operations after national bankruptcy will mean that the little gold available will suffice as a partial anchor to the "new" dollar.

    The rest of the anchor will be contracts on national industrial output (bad term I know) like in Ben Franklin's day.

    2: Uncle Sam just may well call up the ECB and Deutsch Bank and say "play ball with us and confiscate all gold accounts of US nationals at your institutions - or you'll lose your biggest export market to currency collapse".

    3: A world wide banking failure - or worse - a world wide derivatives meltdown - might drive us there overnight.

    4: Gold purchased through custodians like BullionVault.com STILL reside in established banking institution's vaults. BV.Com doesn't have it's own vaults on some volcano island in the Indian Ocean - and are quite vulnerable to governments.

    5: Gold bars in private deposit boxes will have to be re-assayed - since they become suspect as soon as they leave the established vaulting system.

    6: Krugerrands aren't generally redeemed at your local bank teller window. You're at the mercy of private gold dealers and coin merchants. What coin dealer is going to buy them during a banking meltdown at $5000 an ounce ?

    7: Norwegian T Bills are probably your best bet - but try finding someone who will purchase just $50,000 worth. Merrill Lynch told me I'd have to purchase a minimum of $ 1 million dollars worth - and prove I have the experienced background even to approach them for a purchase.

    So - my strategy is to find the safest banking system going (Abu Dhabi) and who know's - maybe Deutsche Bank (a stretch here - so hold the tomatoes) and put my savings into "energy currencies" and out of the hands of currency trading accounts.

    Eric - your research is timely, disturbing and essential. Keep up the great work.

    My best
    Robert
    Riyadh Saudi Arabia

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