More Woolly Thinking From Kauffman

March 01, 2011

Kauffman’s got the ETF-bashing stick out again. And they’re mostly wrong, again.

This report from Kauffman has the advantage of at least being brief. But it’s as full of holes as their previous work, which we spent a good month debunking.

In today’s report, they raise the issue of settlement failure again, but bring in a host of other securities markets, most notably the mortgage-backed securities markets. I’ll be honest: I’m not an expert on the settlement process for MBS trades. I’m not even an “expert” in the process by which equities and ETFs settle. But I’ve been around the block a few times, and know how to make a phone call and read a rule book.

The first warning shot for me in that latest Kauffman report came where it did last time—bad citations. In a tortured introduction, they start off with this:

“All money market, fixed income, and equity trades are mandated to settle at the trade date plus one, two, or three days. Only after T-plus-eight days does the SEC specify that ‘a government securities interdealer broker shall deduct from net worth ¼ of 1 percent of the contract value of each government securities failed-to-deliver contract which is outstanding 5 business days or longer. Such deduction shall be increased by any excess of the contract price of the failed-to-deliver contract over the market value of the underlying security.’8”

If that sounds like gobbledygook, it’s because it is. First off, it’s flat out not true that all trades have to settle by T+3. As we’ve covered here a lot (and which I’ve rebutted to Kauffman directly, previously), market makers in ETFs—that are often on the other side of large trades, and those most directly dealing with harder-to-trade ETFs—have until T+6. However, the National Securities Clearing Corporation “fails” report includes anything over T+3 as a fail, even though it’s not.

Second, notice that “8”? It’s the footnote, which blithely points to Title 15 of the Code of Federal Regulations, the section of the U.S. commercial code that deals with broker-dealers. That would be a logical place for this to be, but the quote actually comes from Title 17 (section 402) and deals with reporting of net capitalization of government securities traders. “A” for effort. “F” for execution.

Things like that make me call into question the rest of their assertions on the markets I’m simply not an expert on.

Throughout the rest of the report, there’s not much more to it than we’ve seen before. They’re raising a red flag on settlement failures, which is, I suppose, admirable. Who doesn’t want orderly markets? And who doesn’t want to minimize systemic risk? But they raise that red flag on a bed of fundamental misunderstandings about how at least our little corner of the markets works (and I would suspect that glossing over reality permeates the rest of the document as well).

Yes, $1 billion in ETFs is, on average, past T+3. Much of that, I think, is settling T+6 with the market makers, just as it should.

But in a market where the daily creation/redemption activity is often +/- $5 billion, is there any doubt that much of this is legitimate market-making activity?


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