ETFs Hurting IPOs, Kauffman Foundation Says

November 08, 2010


Dangers Of Short Selling

The Kauffman study also revisits a theme developed by Bogan Associates LLC in a report the Boston-based money management firm distributed in September that warned of the dangers of short selling of ETFs. While the Bogan report warned of how an ETF might collapse under the weight of its own short interest, the Kauffman report went a few steps further, arguing that shorting ETF could pose systemic risks.

The systemic risks are twofold, according to the Kauffman report. One is that the ease of short selling ETFs makes them ideal potential triggers for marketwide free falls of the kind experienced on May 6 during the flash crash, Bradley and his co-author Litan, vice president of research and policy at the Kauffman Foundation, wrote. The other, less well-recognized danger is that ETFs could be caught in a “short squeeze” should investors for any reason decide they want to cover their short positions.

“Claims by such market participants as The Susquehanna Financial Group that ETFs pose no systemic risks simply are not credible,” the authors wrote.

Of course, both the Bogan and the Kauffman Foundation overlook a crucial fact; namely, that shorting ETFs is very different from shorting individual stocks. An ETF short-seller can have an authorized participant create the shares necessary to cover a short.

In other words, real squeezes aren’t possible in the ETF world because anyone who has to cover shorted shares can have them created by an AP at a price, as opposed to having to scour the market, perhaps in desperation, for existing shares.

Making 'Dark Pools' Lighter

The authors also said the SEC should require all off-exchange trading venues—so-called dark pools as well as internalized trades completed by broker-dealers—to first satisfy all publicly displayed orders at the price they intend to trade. In other words ,it should prohibit off-exchange venues from processing trades at the same prices revealed in the public markets unless the public orders are filled first.

In addition, the SEC should adopt the “trade at” rule it has proposed that would require off-exchange venues to improve by one cent the best-quoted price. Together, these two rule changes would restore value to limit orders now undermined by proprietary routing and internalization techniques, the study said.

The Kauffman study authors also argued that the U.S. Congress exempt small companies with a market capitalization of $100 million or less from complying with regulations under the 1933 Securities and Exchange Act to insure that a true small-cap marketplace, much as existed in the earliest days of the Nasdaq market, can thrive again.

They also said shareholders of small-capitalization companies of $1 billion or less in market cap should be free to choose whether they wish to comply with provisions of the Sarbanes-Oxley Act, which made accounting rules much stricter following scandals at the start of this decade involving now-bankrupt companies such as Enron and WorldCom.


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