Regulators Remain Concerned about the Impact of ETFs on Market Volatility

 

The Securities and Exchange Commission and regulators in the United Kingdom have been investigating exchange traded funds for some time. Part of those investigations are now reportedly focusing on a situation called “settlement fails,” which occurs when trades are not completed on time. Although most exchange traded fund trades have seven days to clear or settle, and the NSCC, which clears all of the trades, guarantees delivery of the shares, a failure to settle in four days is considered as a “fail” by regulators. (“Exclusive: SEC widens probe of exchange-traded funds,” Reuters).

Regulators are concerned by evidence that settlement fails may contribute to market volatility and systemic risk in financial markets. Hedge funds often sell ETFs short (i.e., they sell borrowed ETF shares hoping to buy them back at a lower price). 70 percent of the 20 most-shorted equity exchange traded funds also had the highest number of settlement fails in 2011, according to the article.

The entire impact of settlement fails on investors is not known, but they may have played a role in the brief but violent market vertigo spell known as the flash crash of 2010, in which the Dow Jones industrial average plunged and rebounded 1,000 points in minutes, resulting in numerous failed trades as well as trades that occurred at crazy prices. High-speed trading of exchange traded funds may contribute to settlement fails, and regulators want to better understand any such correlation, as well as links between prices of exchange traded funds and the values of securities in ETF portfolios.

“If you can’t figure out what price a stock is at because there are multiple high-frequency traders using ETFs to trade in and out,” then when a sudden, unexpected shock occurs in the market, “no one is going to know what caused it,” said one brokerage executive.

Page Perry is an Atlanta-based law firm with over 170 years of collective experience maintaining integrity in the investment markets and protecting investor rights.