Report Says ETFs A Major Cause of Market Instability

by Glen Shapiro, LawAndTax-News.com, New York

12 November 2010

In the opinion of a report written by Harold Bradley and Robert Litan of the Kauffman Foundation, exchange traded funds (ETFs) pose a serious threat to the growth of new companies and stock market stability in the future.

The report says that ETFs are distorting markets to such an extent that they are threatening the growth of new companies by effectively curtailing their access to capital. While numerous factors have been pointed to as contributing to the significant downward trend in share issues over the past decade, in its opinion ETFs represent a far more important and heretofore unrecognized deterrent to companies going public because they are artificially distorting stock prices.

“ETFs are radically changing the markets, to the point where they, and not the trading of the underlying securities, are effectively setting the prices of stocks of smaller capitalization companies, or the potential new growth companies of the future,” said Bradley.

Litan added that, “in the process, ETFs that once were an important low-cost way for investors to assemble diversified stock holdings are now undermining the traditional price discovery role of exchanges and, in turn, discouraging new companies from wanting to be listed on US exchanges.”

The report further documents that the proliferation of ETFs also poses systemic risks similar to those that were manifested during the “Flash Crash” in the US stock markets on May 6 this year. Without significant ETF-related reforms, the authors contend, more market instability is highly likely.

The report suggests that the dangers posed by ETFs in US markets can be mitigated with certain remedies, all of which fall under the purview of the Securities and Exchange Commission (SEC).

Specifically, it is said, the SEC should require far more transparency about the liquidity of the underlying securities or instruments represented by an ETF; compel ETF sponsors to explicitly describe ETF creation and destruction processes in product registration and disclosure documents; and require ETFs to obtain opt-in consent from smaller cap companies (or from the exchanges where they are listed) whose stocks are relatively thinly traded.

They believe that the SEC should consider, for both shares and ETFs, prohibiting plain market orders and instead require all market and algorithmic orders to have a minimum price of sale; and seek assistance from the Federal Reserve in requiring custodial banks to report each week their fails-to-receive and fails-to-deliver of equity and ETF securities.

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