While ETFs constitute just under 10 per cent of US equity market capitalisation, they account for over 20 per cent of short interest and over 78 per cent of failures-to-deliver in US equities. While the disproportionate share of short activity in ETFs has raised concerns about excessive shorting and naked short-selling, we identify an alternative cause for this activity related to the market making activities associated with the ETF creation/redemption process, which we label “operational shorting”. We propose a simple methodology to estimate operational shorting and show that our measure is consistent with the economics behind the mechanism. In examining the market implications of operational shorting, we find that it is associated with improved liquidity but that it is also predictive of market-wide indicators of systemic and counterparty risk. In exploring possible mechanisms for this predictive relation, we find there is commonality in operational shorting across ETFs that have the same lead market maker/authorised participant and that market makers’ financial leverage might be a channel that amplifies this commonality, both of which are suggestive of an increase in counterparty risk.
Dr Richard Evans’ research deals broadly with investment decisions. His current research projects explore risk taking on the part of mutual fund managers, the role of broker intermediation in mutual fund investing and the impact of commission bundling and other trading costs on portfolio performance. His research has been published in the Journal of Finance, the Journal of Financial Economics and the Review of Financial Studies and cited by the New York Times, Wall Street Journal, The Economist and Forbes magazine. He has presented his research to the Securities and Exchange Commission, Social Security Administration and the American Finance Association. Evans has also taught executive education courses for investment professionals from Merrill Lynch, Morgan Stanley and Citizens Bank and he is the advisor to Darden Capital Management, Darden’s student run investment funds.