[Senate Hearing 112-400]
[From the U.S. Government Publishing Office]
S. Hrg. 112-400
MARKET MICROSTRUCTURE: EXAMINATION OF EXCHANGE-TRADED FUNDS (ETFs)
SECURITIES, INSURANCE, AND INVESTMENT
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED TWELFTH CONGRESS
EXAMINING EXCHANGE-TRADED FUNDS (ETFs)
OCTOBER 19, 2011
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
TIM JOHNSON, South Dakota, Chairman
JACK REED, Rhode Island RICHARD C. SHELBY, Alabama
CHARLES E. SCHUMER, New York MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey BOB CORKER, Tennessee
DANIEL K. AKAKA, Hawaii JIM DeMINT, South Carolina
SHERROD BROWN, Ohio DAVID VITTER, Louisiana
JON TESTER, Montana MIKE JOHANNS, Nebraska
HERB KOHL, Wisconsin PATRICK J. TOOMEY, Pennsylvania
MARK R. WARNER, Virginia MARK KIRK, Illinois
JEFF MERKLEY, Oregon JERRY MORAN, Kansas
MICHAEL F. BENNET, Colorado ROGER F. WICKER, Mississippi
KAY HAGAN, North Carolina
Dwight Fettig, Staff Director
William D. Duhnke, Republican Staff Director
Dawn Ratliff, Chief Clerk
Riker Vermilye, Hearing Clerk
Shelvin Simmons, IT Director
Jim Crowell, Editor
Subcommittee on Securities, Insurance, and Investment
JACK REED, Rhode Island, Chairman
MIKE CRAPO, Idaho, Ranking Republican Member
CHARLES E. SCHUMER, New York PATRICK J. TOOMEY, Pennsylvania
ROBERT MENENDEZ, New Jersey MARK KIRK, Illinois
DANIEL K. AKAKA, Hawaii BOB CORKER, Tennessee
HERB KOHL, Wisconsin JIM DeMINT, South Carolina
MARK R. WARNER, Virginia DAVID VITTER, Louisiana
JEFF MERKLEY, Oregon JERRY MORAN, Kansas
MICHAEL F. BENNET, Colorado ROGER F. WICKER, Mississippi
KAY HAGAN, North Carolina
TIM JOHNSON, South Dakota
Kara Stein, Subcommittee Staff Director
Gregg Richard, Republican Subcommittee Staff Director
Robert Peak, SEC Detailee
C O N T E N T S
WEDNESDAY, OCTOBER 19, 2011
Opening statement of Chairman Reed............................... 1
Eileen Rominger, Director, Division of Investment Management,
Securities and Exchange Commission............................. 4
Prepared statement........................................... 27
Responses to written questions of:
Senator Hagan............................................ 63
Eric Noll, Executive Vice President Transaction Services, NASDAQ
Prepared statement........................................... 34
Noel Archard, Managing Director, BlackRock I-Shares.............. 8
Prepared statement........................................... 42
Harold Bradley, Chief Investment Officer, Ewing Marion Kauffman
Prepared statement........................................... 47
Responses to written questions of:
Senator Hagan............................................ 63
MARKET MICROSTRUCTURE: EXAMINATION OF EXCHANGE-TRADED FUNDS (ETFs)
WEDNESDAY, OCTOBER 19, 2011
Subcommittee on Securities, Insurance, and Investment,
Committee on Banking, Housing, and Urban Affairs,
The Subcommittee convened at 9:32 a.m., in room SD-538,
Dirksen Senate Office Building, Hon. Jack Reed, Chairman of the
OPENING STATEMENT OF CHAIRMAN JACK REED
Chairman Reed. Let me call the hearing to order, and as a
first point, let me express Senator Crapo's disappointment that
he could not join us here today. He and his staff have been
very actively engaged in this hearing. In fact, his suggestion
and advice about looking at some of these issues was absolutely
critical in organizing this hearing. He has been summoned
before the Joint Committee as a member of the so-called Gang of
Six, and I think you can recognize that as a place he must be.
I hope he can get back here in time, but I just wanted to make
it clear that we worked very closely together on this hearing
and I value his cooperation, his participation, and his
Let me welcome everyone here to the hearing entitled
``Market Microstructure: Examination of Exchange-Traded
Over the last 10 years, exchange-traded funds, or ETFs,
have grown considerably in number and in size. The New York
Times recently noted that ETFs are, quote, ``perhaps the
hottest rage in investing, with some $1 trillion invested.''
ETFs are particularly attractive to some investors because you
can bet long or short and you can leverage your bet, and you
can hop in and out with the trading day to lock in gains just
as with stocks.
While these products were initially marketed to
institutional investors, more and more mainstream investors are
purchasing them. Currently, approximately 50 percent of ETF
assets in the United States are held by retail investors.
Critics of ETFs have labeled them as, quote, ``new weapons
of mass destruction that are turning the market into a casino
on steroids.'' Others believe they are a more efficient,
modern, and tax advantaged method of investing.
So what are ETFs? In many ways, ETFs appear to be a cross
between a mutual fund and an equity security. ETFs allow
investors to invest in a certain basket of stocks or
commodities or track an index. The first ETFs in the early
1990s offered an investor a portion of a basket of equity
securities found in a certain index. For example, an early ETF
gave an investor a slice of a pool of stocks in the S&P 500.
Additional innovation in ETFs has resulted in products that
can magnify returns of various indexes by embedding derivatives
and other forms of leverage. Theoretically, a leveraged ETF
with one dollar from investors and one dollar from leverage
would return 2 percent for each 1 percent movement in the
underlying index. Other ETFs, called inverse ETFs, seek to
return the inverse of an index, such as providing a 1-percent
return for every 1 percent decline in the S&P 500. ETFs are
also popular trading products. According to Morningstar,
trading in ETFs currently generates 35 to 40 percent of
exchange trading volume. Clearly, trading in these products is
impacting the capital markets.
The structure and regulation of ETFs in the United States
differ from ETFs in Europe. European products generally are
marketed to institutional investors and involve more
Regulators are focusing more and more attention on these
ETFs. The role of ETFs during the May 5, 2010, Flash Crash,
when market indices declined significantly in a matter of
minutes, has also focused attention on these products. In
Europe, the Financial Stability Board raised alerts in April of
this year about the increasing complexity, opacity, and
interconnectedness of the ETF market. In the United States, the
Financial Stability Oversight Council recently cautioned both
the United States investors and regulators regarding the
possibility of liquidity and counterparty exposure emanating
for foreign domiciled ETFs. In addition, the Securities and
Exchange Commission, the Financial Industry Regulatory
Authority, and the North American Securities Administrators
Association have issued alerts to mainstream investors who are
increasingly purchasing ETFs as an alternative to mutual funds.
They are also cautioning investors to ask questions about these
complex products and to understand how they relate to an
individual's investment objectives.
Recently, financial commentators have been debating the
degree to which ETFs may be adding to market volatility. One
noted columnist has described leveraged ETFs as the new
derivative and, in his words, the culprit behind late day
Do ETFs put our economy at risk by representing significant
systemic risk concerns? Are they the new weapons of mass
destruction as some have suggested? How do these products
affect trading practices? Are these products increasing market
volatility? Are market regulators dealing effectively with the
growth and risk of ETFs? Are these products affecting price
discovery on traditional equities? What implications do ETFs
have on Main Street businesses and small business capital
formation? And are there adequate controls in the marketplace
to deal with these increasingly popular financial products,
especially for mainstream investors?
ETFs are complex products and these are complex questions.
We are attempting to tackle many of these questions today. I
certainly look forward to the testimony of our witnesses as we
Now let me introduce our panel of witnesses, and let me
also, before I do that, indicate that all of your statements
have been made part of the record, so feel free, in fact, feel
extraordinarily free to summarize your testimony.
Chairman Reed. We will try to give you all 5 minutes, but
the record will be full of your detailed statement and I think
the best way to proceed is to give us sort of your summarized
Our first witness is Eileen Rominger. Ms. Rominger is the
Director of the Division of Investment Management at the U.S.
Securities and Exchange Commission. Ms. Rominger was sworn in
by Chairman Mary Schapiro on February 16, 2011, and is
responsible for developing regulatory policy, administering the
Federal securities laws applicable to investment advisors,
mutual funds, ETFs closed end funds, variable insurance
products, and unit investment trusts.
Prior to becoming the Investment Management Director, Ms.
Rominger was with Goldman Sachs Asset Management as the Chief
Investment Officer, responsible for managing core portfolio
teams, including fixed income, equity, and quantitative
strategies. She previously worked for 18 years at Oppenheimer
Capital, where she was a Portfolio Manager, Managing Director,
and a member of the Executive Committee. Thank you very much.
Eric Noll is Executive Vice President Transaction Services
for the NASDAQ OMX Group, Inc. Mr. Noll oversees the trading
operations of all of the U.S. transactions services businesses.
Mr. Noll joined NASDAQ OMX from Susquehanna International Group
LLP, where he served as Associate Director and Global Head of
Strategic Relationships and as Managing Director of Susquehanna
Financial Group. During his time at Susquehanna, Mr. Noll
oversaw all the exchange relationships, created the Investment
Banking Department, developed an Institutional Equity Research
Department, and was responsible for all options and equity
order flows for the order maker operation. And prior to his
time at Susquehanna, Mr. Noll held a positions at the former
Philadelphia Stock Exchange and the Chicago Board Options
Exchange. Thank you, Mr. Noll.
Noel Archard is a Managing Director at BlackRock and
currently heads the I-Shares product function in North America,
which is responsible for product research and development,
product management, the management of I-Shares in capital
markets, and product services and analytics. Mr. Archard joined
I-Shares in 2006, then part of Barkley's Global Investors,
which merged with BlackRock in December of 2009. He also spent
over 10 years at the Vanguard Group, first working with their
brokerage service unit and then moving into their exchange-
traded funds group.
Our final witness, Mr. Harold Bradley, serves as Chief
Investment Officer for the Ewing Marion Kauffman Foundation,
managing a $1.8 billion global investment portfolio that uses
hedge funds, alternative investments, swaps, ETFs, and other
derivative instruments. Mr. Bradley serves today on the Pension
Managers Advisory Committee of the New York Stock Exchange and
on the Financial Analysts Seminar Board of Regents for the CFA
Institute. He formerly served on the board of Archipelago
Holdings LLC, one of the largest traders of ETF securities,
prior to its acquisition by the New York Stock Exchange. Mr.
Bradley has traded common stocks, managed small capitalized
stock portfolios for American Century Mutual Funds, and worked
on a committee there to understand how to structure actively
managed exchange-traded funds.
As you can see, we have a very impressive panel and thank
you all for joining us today. Ms. Rominger, would you please
STATEMENT OF EILEEN ROMINGER, DIRECTOR, DIVISION OF INVESTMENT
MANAGEMENT, SECURITIES AND EXCHANGE COMMISSION
Ms. Rominger. Thank you. Chairman Reed, Ranking Member
Crapo, Members of the Subcommittee, my name is Eileen Rominger
and I am Director of the Division of Investment Management at
the Securities and Exchange Commission. I am pleased to testify
on behalf of the Commission on the topic of exchange-traded
funds, or ETFs, as they are commonly known.
ETFs are a type of exchange-traded product, or ETP, that
must register as investment companies. Since their inception in
the 1990s, there has been a proliferation of these funds in the
marketplace. As ETFs have gained in popularity, ETPs have
expanded from ETFs tracking equity indexes into the development
of a variety of exchange-traded products, including those based
on fixed income instruments, commodities, currencies, and
foreign securities. This product development has generated
increasingly complex structures, such as leveraged, inverse and
inverse leveraged ETFs. ETFs in the U.S. have grown to account
for approximately $1 trillion in assets, or about 10 percent of
the total long-term U.S. open end investment company industry,
with U.S. domiciled ETFs making up about two-thirds of global
ETFs combine features of a mutual fund, which can be
purchased or redeemed at the end of each trading day at its net
asset value, with the intraday trading feature of a closed-end
fund whose shares trade throughout the trading day at market
prices that may be more or less than its net asset value. Apart
from the fact that ETFs trade intraday, most ETFs are similar
to mutual funds in that they both translate investor purchases
and sales in the fund--and changes in investor sentiment--into
purchases and sales of the underlying holdings. Some ETFs,
however, are structured in a way that require the purchase or
sale of underlying holdings based on movements in the market,
even absent investors' purchases or sales of the ETF. This is
the case for leveraged, inverse, and inverse leveraged ETFs.
Like operating companies or closed-end funds, the offerings
of the shares of ETFs are registered under the Securities Act
and a national securities exchange lists the ETF shares for
trading. As with other listed securities, investors may trade
ETF shares in off-exchange transactions. In either case, ETF
shares trade at negotiated prices.
An ETF, as an investment company, must file a registration
statement with the Commission under the 1940 Act and register
the offering of its shares under the Securities Act. In
addition to registering under the 1940 Act, under existing
regulations, the ETF must rely on an order, typically issued to
the ETF's sponsor, giving relief from certain provisions of the
1940 Act that would not otherwise allow the ETF structure.
While ETFs are typically registered with the SEC as
investment companies, there are other exchange-traded products
that do not hold securities but instead hold commodity or
currency-based assets and therefore, are not subject to the
provisions of the 1940 Act. The issuers of these exchange-
traded products register the public offerings of their
securities with the Commission under the Securities Act and
become subject to the periodic reporting requirements of the
Securities Exchange Act of 1934.
Prior to listing and trading ETP shares on a national
securities exchange, the exchange must file a proposed rule
change with the SEC that, if approved, would permit such a
listing and trading. To approve such a proposal, the Commission
must determine that the proposal is, among other requirements
under the Exchange Act, designed to prevent fraudulent and
manipulative acts and practices, to promote just and equitable
principles of trade, to remove impediments to, and perfect the
mechanism of a free and open market, and, in general, to
protect investors and the public interest.
In addition to the Commission's oversight of ETFs as
investment companies and the public offering of ETP shares and
issues relating to their listing on exchanges, the SEC staff
also periodically inspects and examines SEC registered
investment advisers, broker-dealers, and exchanges in
connection with issues related to ETFs, and, as appropriate,
ETPs. In addition, staff investigates allegations of misconduct
concerning ETPs by market participants. Such misconduct could
include inadequate or misleading disclosures in offering
documents and marketing materials as well as insider trading or
improper sales practices.
Because of the growth and development in such ETFs and
ETPs, the Commission has been actively following, and continues
to engage in the analysis of, these products. SEC staff is
continuing to examine the dynamics of ETF trading, the
arbitrage mechanism designed to keep the prices of ETFs close
to the value of the underlying securities, and linkages, both
intended and unintended, between ETFs and the markets as a
In March 2010, Commission staff determined to defer
consideration of exemptive requests for ETFs seeking to
register under the 1940 Act and make significant investment in
derivatives. This action was taken in light of concerns raised
generally about the use of derivatives by all 1940 Act
investment companies, including ETFs. While staff recognized
that the use of derivatives is not a new phenomenon, the staff
determined that increasing complexity of derivatives and their
growing use by funds made it the right time to reevaluate the
Commission's regulatory protections.
As part of this review, in August 2011, the Commission
issued a concept release seeking broad public comment on funds'
use of derivatives and on the current regulatory regime for
derivatives under the 1940 Act as it applies to funds' use of
derivatives. The comment period for this concept release
expires on November 7 and the staff looks forward to reviewing
the comments that we receive on that concept release and we
will carefully assess those comments in determining how to
Thank you very much for the opportunity to testify today.
Chairman Reed. Thank you very much.
Mr. Noll, please.
STATEMENT OF ERIC NOLL, EXECUTIVE VICE PRESIDENT TRANSACTION
SERVICES, NASDAQ OMX
Mr. Noll. Thank you, Chairman Reed.
As we examine issues around ETFs, we should recall that
these products have done a lot of good for investors since they
were developed 20 years ago. They have reduced the cost of
investing. They have reduced the risk of equity investment and
have broadened the tools to hedge risk. They are a key way many
These are volatile times in our markets, and in such
difficult times, it is natural to look for a cause. ETPs, or
exchange-traded products, are a tempting product, but
restricting ETPs will not solve the debt crisis in Europe, will
not balance the U.S. budget, will not restore bank balance
sheets, and will not add jobs. There are very large, very real
uncertainties driving global market volatility. In fact, ETPs
provide investors with very valuable diversification, hedging,
and risk management opportunities in these difficult times.
These products provide critical benefits to publicly listed
companies. By included in a single diversified security,
companies gain access to a greater audience of investors who
may not have bought the individual stock, meaning the markets
are deeper and more liquid, benefiting all investors and the
economy as a whole.
The QQQ is one of the most widely and traded securities in
the world, and I can tell you from personal experience that the
companies that make up the QQQ consider it a very real
achievement to be included in it.
It is really hard to overuse the word ``transparent'' when
talking about ETPs. That is why some investors prefer them over
similar products, like mutual funds. Mutual funds and ETPs play
different roles in investors' portfolios, but ETPs' low cost
and transparency make them an important category that should
remain widely available.
Since these products were first introduced, innovations
have propelled them from simple indices on baskets of stocks to
a host of other complex financial strategies for investors. I
believe the proliferation of ETPs and asset growth in ETPs has
happened perhaps a little more quickly than the needed broader
education about the products and their structures to investors,
regulators, academics, and policy makers, allowing for the
formation of some incorrect assumptions about the products.
The common flawed assumption is that all ETPs are
constructed the same and are based on and tracked in an
underlying index. That is not always the case, but that does
not infer that the product category is not beneficial to the
marketplace and to investors.
Innovation has allowed ETPs to adapt from ETFs tracking
baskets of domestic securities to more sophisticated products,
in some cases holding derivatives and/or using leverage as a
tool for the product's investment objective. These new products
add value in that they offer new and unique exposure to the
markets. Investor education and disciplined application of
suitability requirements for any prospective holder of a
product will continue to be paramount as ETP numbers grow.
We believe that ETPs are of limited concern when evaluating
them in the context of financial systematic risk. While
activity in ETPs can generate corresponding transactions in the
underlying securities, ETPs pale in comparison with other
financial instruments. Some have tried to use the extraordinary
trading environment experienced over the last year to connect
ETP activity with chaotic trading days. These analyses ignore
the unparalleled uncertainties that the market must process
during the fast pace news and information cycle of the modern
From flirtations with failure in Europe to potential
Government debt payment interruptions in the U.S., our markets
are simply trying to rationalize and apply metrics across far
too many unknowns. ETPs do not cause this. They are just trying
to move within this turbulent environment.
We looked at trading in ETFs on a normal and volatile day,
and it varies roughly in proportion with the overall trading in
the marketplace. When news breaks and market prices move,
trading volumes increase in both the ETFs and the underlying
stock. The largest ETFs track the S&P 500 Index. As a group,
they trade about $40 billion worth of volume each day. The
large, that is relatively small compared to the underlying
stocks, which trade $125 billion in the stocks that make up the
On very volatile trading days, such as those in early
August, trading in both ETFs and the underlying stocks
increased, but many investors managed the market risks using
the ETFs. Trading in ETFs rose slightly more on a percentage
basis than trading in the underlying.
Within those early days in August, ETF volume fluctuated
along with the volume of underlying stocks. Late in day trading
of the stocks underlying the index actually increased
disproportionately, as many investors and traders adjusted
their exposure near the end of the day. Trading in the ETF was
relatively less active late in the day. That is not uncommon,
as many firms and mutual funds and institutional investors use
the closing cross process at the exchanges to balance their
books and to gain their positions.
The trading patterns we observe in ETFs are what you would
expect from a popular and useful investment vehicle. It is not
surprising to see increased volume near the close and when
volatility is high. The amount of the increase is consistent
with the value that these securities provide investors and
traders in managing their exposure to very real macroeconomic
and political events that have driven markets recently.
A quick moment on regulation. NASDAQ, Market Watch, FINRA,
and the SEC monitor activity in all the securities traded and
listed on NASDAQ, including ETPs. The SEC and exchanges
partnered to refine trading rules for all assets, including
ETPs. Trading of the ETPs is protected by the same volatility
protection provided equities.
Following the 2008 financial crisis and the 2010 Flash
Crash, we implemented two market-wide changes to impact the
volatility on stock prices. First, we implemented new short
selling restrictions triggered whenever a securities price
falls more than 10 percent on a day. Second, all markets have
adopted single stock trading pauses that occur when a
securities price moves rapidly over a 5-minute period. The
exchanges and the SEC are working to potentially upgrade the
single stock trading pause to a market-wide limit up/limit down
Finally, comparing the U.S. ETPs with foreign-based ETPs,
like in Europe, clearly, the U.S. product design is superior.
Under the Investment Act of 1940, it is not permitted to have
vertical silos of both the issuers, custodians, index
calculators, and other providers of services to ETFs. In
addition, collateral must be what is issued by the ETF here,
which is different than it is in Europe.
In closing, we feel that ETPs have grown in popularity
because of their proven usefulness in helping investors
diversify and manage risk in today's complicated markets. We
believe that regulatory community is well positioned to monitor
and discipline the growth and innovation within the important
category of financial products.
I am happy to answer any questions you may have.
Chairman Reed. Thank you very much, Mr. Noll.
Mr. Archard, please.
STATEMENT OF NOEL ARCHARD, MANAGING DIRECTOR, BLACKROCK I-
Mr. Archard. Thank you, Chairman Reed. My name is Noel
Archard and I am a Managing Director at BlackRock, where my
responsibilities include product development and our ETF
business, which operates under the I-Shares brand. As a global
leader in exchange-traded funds, BlackRock welcomes the focus
of this Subcommittee on ETFs and related products.
ETFs offer both individual and institutional investors a
low-cost, flexible way to invest in stocks and other asset
classes that track indexes, and they allow investors to
diversify their risk easily and efficiently by accessing
different areas of the global markets within one investment
Investment in ETFs by both institutional and retail
investors has grown steadily over the past two decades. Global
ETF assets are now estimated to be $1.4 trillion. Nearly $1
trillion of that is in the U.S. market. This growth has come
because investors value the transparency, efficiency, and
simplicity of ETFs. However, it is incumbent on our industry
and our regulators to ensure that investors who purchase ETFs
know what they are buying and appreciate the risks and costs
associated with these products.
The first ETFs were relatively straightforward products.
They tracked broad benchmarks, such as the S&P 500 or
individual country indexes. In the past few years, however, ETF
sponsors have introduced more complex exchange-traded products.
As the complexity of these products has grown, some products
have not met investors' expectations and in other cases they
have failed to maintain appropriate standards of transparency
and simplicity. This has introduced new risks to investors that
may not be fully understood, or importantly, may not be
important for long-term investors. Products which raise such
concerns include so-called leverage and inverse funds as well
as products that are backed principally by derivatives rather
than physical holdings.
BlackRock believes that these products should not be called
ETFs. To increase understanding and avoid confusion among
investors, they require a different label. It is important to
note that these products currently make up less than 10 percent
of the ETF assets in the U.S., but they have created concerns
about the role of all ETFs in the marketplace, including the
more than 90 percent of ETF assets that are straightforward
ETFs backed by physical holdings.
One of these concerns is the relationship between the
growth of ETFs and current market dynamics. Our analysis of the
data does not suggest that ETFs increase market volatility.
Indeed, the evidence available to us shows that the broad
dynamics of market volatility are reflective of overall
economic uncertainty. As discussed in our written testimony,
increased market volatility leads to increased investment in
ETFs, not the other way around. This is because ETFs allow
investors to diversify their risk efficiently.
Nevertheless, these concerns must be addressed by the
industry and our regulators in order to ensure that the
benefits to investors provided by the majority of ETFs continue
to be realized. With this goal in mind, BlackRock has called
for new standards for ETFs and exchange-traded products more
broadly to enhance transparency and investor protection.
For the U.S. marketplace specifically, BlackRock recommends
a package of important steps. First, investors should know what
they are buying and what our products' investment objectives
are. As spelled out in our written testimony, this can be
achieved by establishing a standard classification system with
clear labels to clarify the differences between products. The
ETF industry today, both in the U.S. and globally, is not doing
a sufficient job in explaining those differences consistently.
The label ETF should refer only to a specific subcategory that
meets certain agreed standards. That subcategory should exclude
any leveraged and inverse products and any primarily
derivatives based products currently described as ETFs.
Second, investors should understand what the product they
are buying holds. Ideally, the goal should be daily disclosure
of holdings and exposures, though we recognize the practical,
technical, and legal constraints may currently prevent full
disclosure of all portfolio holdings.
Third, investors should have complete clarity regarding all
the costs and revenues associated with any fund they buy so
they can clearly establish the total cost of ownership. In
addition to clearly stating the management fee paid by the fund
sponsor, the disclosure should include the total costs that
affect investors' holdings and returns.
Finally, we believe the SEC should convene a public working
group of market participants to develop clear, consistent
regulations for U.S. ETFs. The SEC should then adopt a rule
that provides uniform treatment of ETFs and enhances
disclosures, particularly for complex and higher risk products.
In conclusion, we at BlackRock believe that all
participants in this growing marketplace should be guided by
transparency in all aspects of the product structure. BlackRock
is committed to working with regulators, other market
participants, this Subcommittee, and other policy makers to
help ensure that this package of important reforms is adopted
on a timely basis.
Thank you, and I will be pleased to answer your questions.
Chairman Reed. Thank you very much.
Mr. Bradley, please.
STATEMENT OF HAROLD BRADLEY, CHIEF INVESTMENT OFFICER, EWING
MARION KAUFFMAN FOUNDATION
Mr. Bradley. Thank you, Chairman Reed. First, I would like
to say the reason I am here is I am not in this business. The
reason I am here is that Kauffman Foundation in Kansas City
focuses specifically on entrepreneurship in our country and how
we can foster the growth of our capital markets and economy.
And so my concerns expressly reside in what we are doing to
capital formation, especially smaller companies.
The charts in front of you go along with the comments I
will make from our much more extensive commentary.
We are here because ETFs, in our opinion, in concert with
other derivative products, have radically altered equity
markets. Chart 1 that you have in front of you shows that over
the past dozen years, while more than 30 percent of publicly--
of U.S. domiciled publicly traded companies disappeared, no
longer trade--that is a crisis in itself--the number of ETFs
About half of all U.S. stock trading now involves ETFs
based on some analysis in the book that came from J.P. Morgan,
and in Chart 9, you can see--that is in the second chart that
you have in front of you--Chart 9 shows that trading in ETFs
and futures now exceeds the value traded in underlying common
stocks. So this is not just an ETF product. It is an arbitrage
between ETFs and futures that creates the jurisdictional
problems and, I think, the regulatory issues.
Second, recent data shows large redemptions from mutual
funds offset in part by increasing assets in ETFs, a trend
driven largely by the very favorable tax treatment accorded to
ETFs that is not accorded to those who invest in mutual funds.
Third, ETFs are like many financial innovations that carry
big risks when they are taken too far. We believe that is where
we are today. One problem is with ETFs made up of small
capitalization stocks, and while BlackRock is a great firm, I
am going to spend my time talking about the IWM, in particular,
because that is the one I have studied as a former trader and
ETFs geared to small companies, like the IWM, own stocks
that are inherently difficult to trade. Heavy trading in such
ETFs immediately cascades into the prices of the underlying
stocks, which then follow the index, not a possibility
envisioned by the original ETF theorists who intended only to
track common stock prices.
Chart 6 shows that the IWM is one of the largest owners of
more than 1,700 small company stocks. The IWM is but one of
dozens of small cap and narrowly constructed ETFs that
increasingly trade such exotica as lithium-related stocks and
call that an index, stretching the idea of an index far beyond
what my experience would tell me represents an index. If you
are a growing, privately held company, you will think long and
hard about becoming one of the tiny boats on giant ETF ocean
waves before deciding to go public.
Moreover, small cap stock ETFs may catalyze market
instability. In Chart 2, you can see how IWM prices led the
sell-off during the May 2010 Flash Crash. That was not
referenced at all in the SEC report with other regulatory
overseers that focused mostly on what happened in large cap
You can see the opposite in Chart 3. When IWM prices just 2
weeks ago rallied 7 percentage points in the last 20 minutes,
it was remarkable, and yet there was no wide reporting of this
in the news. In our view, volatility up is as bad as volatility
down. These are symptoms of the same disease and terrify stock
market investors but not the day traders and market makers who
thrive on volatility as traders in ETF products and futures.
The problems are not limited only to small company stocks.
Chart 4 shows that arbitrage trading between large cap ETFs and
futures contracts has resulted in the comovement between stocks
of the biggest U.S. companies and indexes that is
unprecedented. During the parts of the last year, Ned Davis
Research shows that the S&P 500 moved in lockstep with its
stocks more than 86 percent of the time. The idea is the index
should move differently than the component stocks individually.
This is remarkable and also unprecedented, reminding us only in
the data you are looking at of the 1987 crash, when the Dow
Jones Index dropped 23 percent, a casualty of portfolio
insurance. When stocks move together like this, especially when
there is no investor panic, then our stock markets are broken
and failing to perform crucial price discovery functions for
Finally, the third problem relates to our concern about ETF
settlement failures. This is again in the plumbing of the
system. Nobody likes the plumbing. Chart 12 shows that traders
in the two largest ETFs accounted for one-fifth of all
settlement fails in the U.S. stock market last year. When a
buyer has sent the money but the securities do not show up at
the custody bank on time, this creates potential problems for
the financial system, in our opinion. We fear that custody bank
oversight of settlement is lax and could contribute to a
systemic crisis when hedge funds, commercial banks, and ETF
traders withdraw collateral or otherwise fail to honor trading
obligations, as has happened before. The best anecdote to
system liquidity disease is on-time settlement of all
outstanding trades effectively enforced.
Thank you for your time.
Chairman Reed. Well, thank you very much, Mr. Bradley. Just
for my information, IWM represents----
Mr. Bradley. The Russell 2000 Small Cap Index, so it is
geared specifically to match that index's returns over time.
Chairman Reed. Thank you very much.
Well, this has been an extraordinarily, I think, helpful
set of statements, and I am in the very enviable position of
being the only one here, so I can ask lots of questions and I
intend to do so.
I must say, one of the things that prompted the hearing is
this sense, perhaps, and again, we want to get the experts here
to see if it is sense or just sort of an overreaction, that
this sort of deja vu of a product, very useful product, coming
online, but then growing substantially in terms of volume,
growing substantially in terms of complexity. And I know the
European markets have much more derivatives backed ETFs. And
then some of the market issues we have seen with respect to
volatility, with respect to pricing underlying stocks, et
cetera. So this is, I think, a very appropriate time, and I
commend the SEC, frankly, for beginning to look very closely at
this, to start asking, I think, very difficult questions about
ETFs, and so let me begin that process.
One is suggested by the testimony of Mr. Archard--Ar-shard,
am I pronouncing that correctly?
Mr. Archard. Archard.
Chairman Reed. Ar-chard, OK. I am from Rhode Island.
Chairman Reed. If there are two ``a''s in a word, you are
just--I will never get it right. I will say it five different
ways. Forgive me up front.
But the notion of, really, what is an ETF these days. It
started out as pretty vanilla, as you suggest, and now they are
inverse. Sometimes they are supported not by the underlying
stock that they are tracking but by derivatives in another
stock that may have no correlation. The issues of transparency,
And you bring up the point, and I would like the whole
panel to comment, but let you begin, sir, about how we might be
able to start distinguishing true ETFs from the other
instruments, so please.
Mr. Archard. Sure. Thank you. This has really stemmed from
the fact that BlackRock, and with I-Shares being a global
provider, we do see all flavors of exchange-traded products
around the globe, and as we have done work over the last
months, a lot of what we have thought about is--this is not to
pass judgment on one product is better than another. In the
U.S. regulatory scheme, we tend to see more, you know, what is
the disclosure base around a product rather than does it have
merit for everyone that might possibly use it.
The important part was to say, put in some classification
systems to essentially create speed bumps, something that will
flag for investors, I should stop and see, do I understand it?
If something is called an ETF in the U.S., I think that would
mean it would be regulated by the '40 Act and all the good
stuff that comes out of that as far as diversification of
holdings, physical holdings, limits on derivatives that might
be in the product. If it is labeled an ETN, exchange-traded
note, it means something else. If it is exchange-traded
commodity, that means something else with maybe different tax
ramifications for the investor. And everything else would
become an ETI, exchange-traded instrument.
We have put this in our written testimony and put out some
viewpoints on this in the last week, again, the idea being
FINRA actually did some work since 2009, along with the SEC, to
raise the awareness around some of these products, which are
pretty much less than 10 percent of the ETF market today. But
we think, take it a step further. You can never have enough
disclosure, enough education to the investing public. Something
as simple as changing the naming classification will be another
plea to investors to pause a moment, understand what they are
Chairman Reed. Let me just follow up with a quick question,
since--if you are a retail investor in the United States, how
easy is it to buy these European ETFs that are not regulated by
Mr. Archard. Pretty difficult. I mean, I would say that
what we observe is that investors outside the U.S. have a much
easier time, or a bias toward buying anywhere. For U.S.
investors, the overwhelming majority, especially for retail in
particular, they are buying U.S. listed products. As you get
maybe into the ultra-high net worth sphere, you might have
access to other types of products. But for the majority of
retail ownership, it is U.S. domiciled.
Chairman Reed. OK. Let me go, Ms. Rominger, to your
comments on this whole issue of the different classifications,
and also, I think, following up on my last question, to the
extent that you are seeing it easier for people through
intermediaries to get, like the European, for want of a better
term, style retail.
Ms. Rominger. From the standpoint of investor protection,
which is one of our most important missions, along with
facilitating capital formation at the SEC, I think that
transparency is incredibly important. I think that increasing
investor knowledge of the features of ETFs is very important.
The SEC and FINRA put out an investor alert some months ago
regarding leveraged and inverse ETFs. I think that the
classification system that Mr. Archard described is very
interesting and deserves serious consideration.
Chairman Reed. Let me follow up with a question of how
transparent are the portfolios and the positions of the ETFs
that you regulate? Can a retail investor sort of see in real
time what the portfolio is and what they are underlying?
Ms. Rominger. For the vast majority of funds, there is a
high degree of transparency. There may be a couple of
exceptions to that, but for the vast majority, we put a very
high value on that transparency. We think it is really quite
critical to the arbitrage mechanism that makes ETFs work, and
further, that transparency is one of the key benefits that the
ETF portfolio offers to investors.
Chairman Reed. Mr. Noll, your comments, and then I will ask
Mr. Noll. Thank you. First of all, I would like to say we
are not an apologist for any type of ETF, but we do believe
that innovation in financial markets and in these products is
incredibly important and that we should not unnecessarily
restrict their development.
That being said, NASDAQ is in favor of increased
transparency around these products, what they are, how they
work. We also think that disclosure will solve many of these
problems. And I also would like to stress the suitability
requirements that broker-dealers currently have for all of
their investors. So every broker-dealer has a responsibility to
make sure that their customers are only investing in products
that are suitable for their financial condition and their
Last--this is more of an observation--these products are
not new. What is new with these products is that they are
packaged and listed on exchanges. These products have existed
for quite a long period of time in the United States markets.
Traditionally, they have been traded in the dark. They have
been packaged for high net worth individuals and institutions
as very specialized products. The benefit of these kind of
products for today's financial markets is, in fact, they go
through a transparent registration process at the SEC. They are
listed on exchanges with transparent prices that can be tracked
and followed. So to a large extent, this creates the
democratization of a product that was exclusively in the
bailiwick of high net worth individuals and other institutions.
And last, I would like to point out differences between our
markets and the European markets here in that our SEC rules
have a very unique separation of roles and how these products
were brought to market, so that individual firms cannot be all
things to all people in the creation, redemption, custody,
pricing, and underlying index calculation as they can be in
Europe, and that separation of powers and that very explicit
understanding of each role's duties actually are important
safeguards on how these products differ.
Chairman Reed. Mr. Bradley.
Mr. Bradley. Senator Reed, I think your first question was
what is an ETF, and that is increasingly difficult to answer. I
think there is a false dichotomy between what happens in
European markets and U.S. markets because they are the same
global sponsors and the same trading firms.
My big concerns about ETFs are not about the sponsors, it
is about who trades these instruments, who is providing the
IOUs that we call swaps. A swap is nothing more than an IOU. So
in 2008 when the collapse happened in our capital markets, big
contracts were underwritten and guaranteed by AIG in London and
they ceased trading. Well, we bailed them out, so the AIG
contracts were good, but I think that that reverberates around
our entire capital market system and that to say, well, the
collateral is different or derivatives are different, MiFID II
will probably take care of some of that.
But I think there are some real concerns about short
interest that is reported in these big ETFs that represent more
than 100 percent of outstanding units. The sponsors say, not my
worry. They are all registered with us. We know who they belong
to. If they are lending them to each other, not our concern.
Well, then you must have a huge daisy chain of people lending
and collateralizing and securitizing, and they are trading and
doing various trades. Who is watching that? Who is watching
what happens to these hedge funds?
And so my real worry is that we have a '40 Act exemption
creating the products, sponsors acting as fund advisors, as I
used to for a mutual fund, but not watching who is trading or
doing what because they do not have to worry about it. The
shares are just delivered into them every evening or redeemed
away. And so it is somebody else's worry, and that is my worry.
Chairman Reed. And the market maker is the concern, the
person you are concerned about.
Mr. Bradley. Yes, sir.
Chairman Reed. That is the intermediary between the trading
platform and the sponsor of the fund.
Mr. Bradley. And I would point out, in the last year, the
SEC has reported doing--they filed an action probably 6 months
ago for stripping, which would probably have come out of the
Division of Enforcement, where they basically accused a hedge
fund manager of going long on insider information, buying a
stock on insider information, hiding it through a series of ETF
transactions in a very narrowly constructed ETF basket.
Chairman Reed. Again, I think we are at a point where we
want to ask the challenging questions, because we have in the
past seen situations where innovation looked very attractive to
us until it exploded, and then it looked very dangerous to us.
So I think the question is vitally important at this juncture.
One of the other aspects here is the issue of price
discovery, and I think, Mr. Bradley, you alluded to it, on the
underlying stocks, because as you suggested, and I think the
common sense or the convention view was these indexes, ETFs,
started tracking the stocks. The stocks moved, the index moved.
The stocks moved, the index moved. And now there is at least
some evidence suggesting that as the ETFs become more powerful,
they move and they push the stocks around.
And again, I want the whole panel to be able to comment on
this very important issue, but this price discovery issue and
the effect on the underlying equity, and as you suggest, on
capital formation, on participation. Your comments, please.
Mr. Bradley. Well, I think you have summarized my views
pretty well, that in small cap and especially in these very
narrow industry strategies--and I will say, again, none of this
is really very public. I was able to sit down at a meeting in
New York City with five very--they were known hedge fund
managers where I wanted to walk through these theories, and
they basically said, yes, we believe that the trading of these
industry baskets are driving what is happening in the
individual securities. And there are many interesting
strategies that are set up, because if you make an index move,
the components of an index, depending on their characteristic,
have very different trading characteristics. So traders exploit
weaknesses in systems to make profits, and I think that that is
Chairman Reed. Let me just go to Ms. Rominger, because this
seems to be directly within your review of these products, the
underlying effect on capital markets, on the prices of the
underlying equities. Have you formed a conclusion, or is that a
topic of your analysis?
Ms. Rominger. This, among other aspects of ETFs and their
trading, is a part of the review that is occurring across the
SEC in several different divisions, including Investment
Management, the division I am responsible for, Trading and
Markets, our Division of Risk Strategy and Financial
Innovation, and Corporation Finance. So we are working together
to study these issues.
You know, I would say that with respect to any types of
portfolios, index funds that are in regular mutual fund form,
ETFs, or even actively managed portfolios, when more investor
capital pours into those portfolios, it causes the prices of
the underlying securities to rise, and when money goes out of
those portfolios across the board--index funds and actively
managed funds and ETFs--it is money moving out of the markets.
So it is not altogether surprising that that would be the
effect on ETFs.
Chairman Reed. No, I guess it just strikes me--and again,
the old fashioned notion that you have got an equity in a
market that should respond to the price and earnings of the
company, the potential of the company, the new patent that they
have just announced, et cetera, and all of that gets
overwhelmed because they are part of a big ETF that is bouncing
Ms. Rominger. Part of an index, yes.
Chairman Reed. ----index, and so the old fashioned, gee, if
we run a really good company, our stock will reflect that, it
just--maybe I am a traditionalist, but that strikes me as at
least a slightly different phenomenon than we saw in the past.
Ms. Rominger. A number of analysts and academics have noted
that feature of index-driven investing for quite some time.
Chairman Reed. Again, Mr. Noll and Mr. Archard, please.
Mr. Noll. So a couple observations. One is that in volatile
times--and there has been a lot of academic studies that
suggest this and look at this very carefully--in volatile
times, correlations of assets tend to collapse to one, as they
say. So we have gone through an extraordinary 3- or 4-year
period of high volatility. It is no surprise to me as a market
observer that assets through that period of time tend to track
one another more closely than they would at less volatile
times, because as investors look out at the marketplace in
those high volatile times, they are looking to protect
themselves more directly than they are in individual stocks.
So the collapse or the correlation between assets in those
kind of environments is not a surprise to me. I do not think it
is a function necessarily of indexing. I think it is a function
of the overall economy and investors' perception of that.
A further observation. Apple Securities, while not a small
cap stock by any means, is probably one of the more widely held
stocks in ETFs. If you look at the return of Apple compared to
the S&P 500 or any other index that Apple is in, you would see
that Apple stock has radically out-performed the indexes. As a
matter of fact, if you stripped out the beta return of Apple
over that period of time, you would see that its return,
holding the market returns constant, is probably a return in
the 80s, 80 percent, which suggests that individual stock
performance, when it does appear, actually does continue to
exist and is not obviated by its inclusion in indices.
Chairman Reed. I just want to follow up on that point, Mr.
Noll. I think Mr. Bradley made the point--and if I have
misstated, please state it correctly--that--and this might be
coincidental, but as ETFs and other products like this have
proliferated, sort of the listings of individual stocks in the
markets have tended to decline. Is that----
Mr. Bradley. Well, I would not say that they are causal----
Chairman Reed. No, I----
Mr. Bradley. ----but I am saying that we have far more
packages for far fewer gifts, or far more gift wrapping for far
Chairman Reed. But it is the implication that not wanting
to be caught up in this kind of a basket so that your own
individual behavior is not measured is dissuading people from
Mr. Bradley. So, Senator Reed, this is one that is
anecdotal that we would come across this in our work, and I
have no statistics to back it, but we have reports from people
that say the market scares them----
Chairman Reed. Right.
Mr. Bradley. ----and with the other costs and other parts
of our regulation, including 404, that these issues are
Chairman Reed. We have lots of reasons why people are
telling us that they do not want to go and do IPOs, et cetera,
and again, that goes back to this whole health of small
business, of growing in this environment. But I guess this is
an issue at least we should have on the table, and I will
just--either Mr. Noll or Mr. Archard, if you want to comment.
Mr. Noll. If you do not mind, Noel, I will go first.
Mr. Archard. Please.
Mr. Noll. So, yes, capital formation matters a great deal
to us. NASDAQ is particularly a growth market. We look to list
new stocks. We hope to see new companies grow. We think it is
important for job creation. We think it is important for
I have to be honest, though. We have never heard of a
company not going public because they were concerned about ETFs
or the way indexes work or having any impact on that.
The issues they do raise for us about capital formation are
404 and Sarbanes-Oxley reform, the current economic
environment, and the difficulty of taking a company public in
that kind of an environment, tax policy, and the fact that many
of our marketplaces have gotten away from what I would say
supporting venture markets. So we look at Canada, for example,
who has a very vibrant venture capital market based in
Vancouver, has over 6,000 companies listed on it and those
companies go public on that market and then graduate to the
main Toronto Stock Exchange. We have no such functionality here
in the United States.
So I think the support of those kind of ventures, of which
NASDAQ has started one called the BX Venture Market, are more
important to helping us fix how do we create capital formation
than worrying about whether indexes are impeding capital
Chairman Reed. Good. Let me--Mr. Archard, you should be
able to comment on these. Please.
Mr. Archard. Much of it has been touched on. I will just
very quickly say that, to the point of inclusion in an index, I
think Eric summarized this in a nice way, but every stock has
an element of market risk in it and it has stock specific risk
in it or returns built into it.
The majority of the largest funds out in the ETF industry
today are market cap weighted stocks, which means that the
largest stocks, most liquid stocks, make up a heavier weighting
in the index that they are represented. And there are very
simple rules that have to be passed for an ETF to be created to
ensure that there is liquidity in the marketplace so that you
do not have complete cause and effect impacts.
Investors move into asset classes based on what they think
the returns will be and the risks commensurate with it. If they
think small cap is going to do well this year, we see investors
move into small cap. If they think emerging markets are too
scary, they move out of emerging markets, and we see this both
in retail and institutional.
And I think it is important to recognize that the ETFs are
just another way of accessing this. ETFs are essentially, as
you pointed out, mutual funds that trade like stocks. These are
investment pools that have to be tradable, and investors have
taken money from individual security trading and moved in some
cases to ETFs, in others from mutual funds and into ETFs, but
it is a zero sum game. If people are going into small caps,
they would be going into small caps.
One final point that I would like to just respond to the
comment that sponsors are not worried about what is going on
once these products are on the marketplace, as a large sponsor,
I do not agree with that assertion. As I said, the one common
element for all of the clients that use ETFs is they have to do
the trade. The functioning of the market structure, the health
of that ecosystem is very important to us, and most of the
sponsors actually spend a lot of time every day monitoring what
is going on within their individual securities, within the
market system, to ensure that they are trading the way that we
anticipate they should be trading.
Chairman Reed. Let me ask another question, because I want
to be fair in terms of giving people a chance to respond first.
Mr. Archard, going back to you, to what extent is this tax
benefit a real inducement to using ETFs versus mutual funds
versus buying the equity?
Mr. Archard. I would say there is, in those three examples,
there are obviously different ways. Every client, whether they
are taxable, nontaxable, is going to make a decision across
products as to what is more interesting. The tax efficiency of
ETFs comes through the fashion that they are brought in and out
of the marketplace. It is an in kind creation redemption,
meaning securities passed back and forth rather than trades
going off within the portfolio as you would see within
traditional mutual funds.
However, just to clarify, mutual funds do have the ability
to redeem in kind, as well. This is done at times for
institutional level types of mutual funds. So while this is
used to greater extent within ETFs and, I think, has been a
feature that clients appreciate, that they are not going to be
paying someone else's tax bill for activity that is going on
within the portfolio, that has been an incentive. But it is not
something that is exclusive to ETFs. But I would absolutely say
the fact that ETFs are far more fair from the sense of an
investor paying their own freight has been something that has
resonated with a lot of investors. It is part of that
transparency. I am getting what I think that I am getting.
Chairman Reed. Mr. Bradley, do you have a comment?
Mr. Bradley. Well, I think that I would agree with his
point of view. I think that it is very hard to argue this. As a
retail investor, I would not want to be in a mutual fund, and I
used to manage billions of dollars effectively. But when
markets go down like they did, 20 percent last year, and I sell
one stock that I have had for 5 years to meet redemptions, they
are hit immediately with a capital gains tax and any dividends
that are paid out by the stocks in that mutual fund, even
though the unit value of their investment is down 20 or 30
percent. And I know that there has been a quest for revenues
and that has been an off-the-table debate for 20 years. So we
create a tax end run in ETFs, which I think really legitimately
serves the interest of retail investors and should enhance
capital formation. But it is a major driver from the financial
advisers I have talked to for the very reasons that Mr. Archard
Chairman Reed. But you do not see it distorting--you do not
see products being created just to have a tax effect. Many
times, there are transactions in business that have no economic
value, but they have a really great tax value. But your view
is, so today, at least, that these ETFs are not being
structured as sort of a--simply as a tax vehicle, not as a
valuable economic investment?
Mr. Bradley. Senator, if you are thinking it, somebody out
there is doing it.
Chairman Reed. That is--OK. Well, if I am thinking it, and
I am not the smartest guy, then I guess somebody is doing it,
Mr. Bradley. I will tell you that I have had friends of
mine call and report--that give a lot of speeches on this kind
of topicality on the West Coast--that they have said, you know,
this is a strategy I would love to see, and I would say the
bigger funds do not do it, but there is a rugby scrum for who
is going to sponsor ETFs right now, and they will create for
their customers what the customers would like.
Chairman Reed. So we should all be aware of particularly
the construction of new funds, if they have generally more of a
tax avoidance purpose than an economic investment purpose, is
Mr. Bradley. Well, I think that would be very unique,
though, to the individual. I mean, I do not know how you would
do that in a generic way.
Chairman Reed. Again, I am just raising the question. I do
not have an answer.
One of the issues that I think is critical to talk about,
which has been, again, alluded to by several comments in the
testimony, is the volatility issue. Are ETFs contributing to
volatility? Mr. Bradley, one of his concluding charts suggests
that the IWM sort of was leading the way down in May of 2010
and leading the way up in October of 2011. Ms. Rominger, your
comments about volatility. What are you doing at the SEC to
sort of analyze this issue?
Ms. Rominger. We are analyzing it. Those who have made
comments about ETFs contributing to market volatility are
generally referring to the fact that leveraged and inverse ETFs
typically rebalance toward the end of the day and, therefore,
same direction volatility in the market at the end of the day
would tend to support the thesis that ETFs might contribute to
that. So it is something we are doing more work on and we hope
to reach some conclusions on that in due course.
Chairman Reed. When you mention leverage, that sort of
raises the specter of some of the products that we found to be
most disruptive in 2008 and 2009, particularly in an
environment as we have today, when the effective rates are 1
percent or less in terms of the Fed. Are these leveraged ETFs,
which are sold to retail customers in the United States, are
they posing a special problem? I mean, that is--I guess one of
the lessons of 2008 and 2009 is we over-leveraged, and now we
are looking at a product that looks like it is more and more
attracted to leverage, leverage, leverage, leverage. What are
Ms. Rominger. Well, that leverage and the use of
derivatives in leverage and inverse ETFs and concerns about
those funds with respect to our investor protection mission at
the SEC caused us to pause in our issuance of exemptive orders
for new ETFs that wanted to use derivatives. And so in March of
2010, we put out a press release indicating that we would not
issue any further exemptive relief for those types of ETFs that
made large use of derivatives.
We also indicated at that time that we were doing a study
more broadly on derivative use across all funds. In August of
this year, we put out a concept release regarding the use of
derivatives in mutual funds. The comment period is over in a
couple of weeks and we really hope to get some good
observations and data and thoughts in response to that.
Chairman Reed. Mr. Archard--and again, I will pronounce it
five different times differently, forgive me--but Noel----
Mr. Archard. Much easier.
Chairman Reed. Actually, in Rhode Island, it is pronounced
Chairman Reed. But these are the type of funds you were
referring to as it might not be properly characterized as ETFs,
these highly leveraged or derivative-based----
Mr. Archard. Correct----
Chairman Reed. ----so that BlackRock's position would be,
one of the things we might do is, so there is a clear sort of
line of demarcation between ETFs tracking a traditional index,
the basket composed of the same components as the index, is
that a fair point?
Mr. Archard. That is correct. That is the point of the
classification system. That is a separate issue from is there
volatility present because of that, but we said, just as a
marker, as a simple way for investors to understand what they
are buying and know, is this something that I want to utilize
in my portfolio or not, it is another mechanism to do that.
Chairman Reed. And the volatility issue, so that you could
respond, and then I will ask Mr. Noll to respond.
Mr. Archard. Sure. On the volatility issue, again, I think
these are studies in progress. As I said earlier in my
testimony, and we have described in a little more detail in the
written, the inverse leveraged are less than 4 percent of the
ETF market. It is a very small number when you look in the
context of the trading day. The importance, obviously, is to
look at the end of the trading day, what is happening in the
last 15 minutes or so to try and assess the impact there. By
any measure, given the fact that the majority of these products
are trading in some cases using products that are not the
underlying securities, meaning that they might use underlying
derivatives to achieve that position, that dollar impact could
be further diluted. So I think the studies still need to be
done in a robust manner across the industry to get to the data
to see it.
I think one point of confusion--I have seen both points
argued and I think it is a little silly--is the sense that it
is either causing directional volatility, and over the last few
weeks now people think that the whippiness at the end of the
day is being caused by inverse leverage, that, we clearly feel
cannot be the case because of the way the products are
structured. Directionally, the end-of-day whippiness does not
make any sense.
Chairman Reed. Mr. Noll.
Mr. Noll. We have not seen any signs that either leveraged
ETFs or ETFs in general add volatility to the marketplace,
either during the day or at the close. We run a fairly robust
closing cross process that publishes in balances as we come
into the close. We have seen no disruptions in that process as
we have gone through the day. As a matter of fact, we have seen
very high active participation in those closing crosses by both
sides. A closing crossing auction only works when you have both
buyers and sellers participating. Our closing crosses have only
gotten stronger over the last couple of months in terms of the
volume that we have done in them as opposed to weaker, and that
suggests that there are ample buyers and sellers participating
in those closing cross processes, actually probably reducing
volatility as we come into the close as opposed to increasing
I think Noel made an interesting point, as well, which I
think is important here, is if the focus is on leveraged ETFs,
they tend not to hold the underlying equities. They tend to
hold the derivative and then Treasury notes or money market
funds. And so their rebalancing tends to be in either the
futures market or a total return-like swap, and yes, those have
equities underlying them that eventually filter back into the
marketplace, but not necessarily at the close and not
necessarily on that day.
Chairman Reed. Mm-hmm.
Mr. Noll. So there are lots of other reasons why there may
be volatility in the marketplace that I think far overwhelm any
effect that the ETFs might have.
Chairman Reed. There is another aspect here, and I might
not get the technical terms correct, but in this whole issue of
the Flash Crash, there were a number of trades that were
initiated but were never settled. They were--I do not know if
that is the--there were lots of orders that were placed but
never fulfilled, et cetera. Is that a problem in terms of--and
I think Mr. Bradley--I know Mr. Bradley in his testimony talked
about the lax enforcement of commercial banks in terms of the,
basically, settlement of some of these transactions. That is
the back end.
You see the volatility up front in terms of the number of
sell orders or buy orders, et cetera, but when they do not
settle a day later or 2 days or 3 days later, some of that--
there is a suggestion in the report that the SEC did was trying
to sort of run up prices or run down prices in the market by
order activity with no real intention of closing the deal. That
is the other part of the volatility. Are you seeing any of that
in the context of----
Mr. Noll. I think there are two issues that you are
raising, and I think it is important to separate them. So one
issue is whether there are lots of orders placed in the
marketplace that go unexecuted, and that is a market structure
issue that we and the SEC and other market participants have
spent a lot of time working on, particularly post-May 6, and we
will continue to work on that and how can we enhance or
otherwise make our markets more secure for users and more
stable for users, and I think we have made some good progress
I think that is different than the other problem that Mr.
Bradley is raising, which is what I have called the fail
problem, when ETFs are transacted and not delivered.
Chairman Reed. Yes. You are absolutely right.
Mr. Noll. So if we separate those two for a minute, if that
would be OK----
Chairman Reed. Yes, please.
Mr. Noll. On the fail side, I think the--well, we have
seen, and we are not in the back office business, so my
observations are as a market observer, not a participant, but
what we have seen there is that we have not had any customer
issues with getting deliveries of ETFs. We have not heard of
anybody raising those issues. I think the fails are really a
function of cost efficiencies provided by both sponsors, prime
brokers, and other lenders into the marketplace about the way
ETFs are settled and securities are created and redeemed as a
way to minimize cost. But we have not seen anything that
suggests that there is an impending or difficult problem with
customers not receiving their trades as transacted in the
marketplace and we have seen no issues with that.
Chairman Reed. Let me go to Mr. Bradley and ask you to deal
with those two issues, one, the settlement issue, and I think
you defined it very precisely and I appreciate that, and the
issue of initiating trades.
Mr. Bradley. So we have raised the issue of the
settlements, which we think is an issue, and the answers that I
get from talking to exchange officials and others change. It is
all because somebody out there somewhere is taking care of this
and nobody is complaining. Well, our view is that capital that
should be going into the creation units that would then go into
the stocks, if it happened in a more timely fashion, you remove
the daisy chain effect I talked earlier when you have enormous
short positions which are units of a, say, a BlackRock
sponsored ETF lent to A, who then lends to B, then lends to C,
then lends to D, and that is where the issues come in a
systemic problem. Now, people say we are well collateralized. I
have heard these arguments my entire career. That is where we
think there needs to be focus.
The other issue you raised that was raised extensively in
the report on the Flash Crash is called high-frequency trading.
The order cancels there, I do not think, and I have a very--I
am not a traditionalist in this thinking--it is actually
beneficial because these people are making markets all the time
in all these securities, and as soon as their electronic books
are balanced, so if I buy something in GM, I might cancel my
Ford order, and so they are constantly using algorithmic
activities to balance these.
The trading costs for investors in mutual funds as tracked
by ITG have dropped significantly in the last 5 years. They
have dropped significantly. And so the retail investor is a
huge winner in the transaction of individual common stocks.
Now, without high-frequency trading, we could not do ETFs,
so the problem now somewhere is going to be a speed bump
between ETFs and common stocks, or, I would say more broadly,
ETFs, futures, and common stocks, to break down these
The last point I would make on that question is I do have a
chart in here, Chart 8, that goes back to your volatility
question. This is in my written testimony. In Chart 8, J.P.
Morgan did a chart in their Delta One Derivatives Desk--of
course, Delta One now has new notoriety after UBS in London--
but the Delta One Desk called this a correlation bubble, and
the reason that they were worried was not that ETFs--and they
did not mention ETFs as the problem, that is my analysis and
inference--that typically Mr. Noll is right. Correlations
increase during times of great stress, like when we were in the
volatility index at a reading of 80. Over the last few years in
between the last crash and now this bout of market turbulence
recently, we had very low volatility times when the comovement
of stocks stayed at unprecedented levels. So that is that
little red dot hanging up there by itself. Something has
changed in the way markets act.
Chairman Reed. Let me just ask a final question to follow
up. With regard to the settlement issue, who is responsible--if
it is a problem, who is responsible for sorting it out? Is it
the SEC? Is it other regulatory agencies? Is it the markets? Is
it the trading platforms?
Mr. Bradley. Well, when I was trading and managing money, I
would ask the custody bank when I was worried about naked short
selling of common stocks. Penalties that I believe the SEC put
on did away with that problem. The question is, do we need
similar remedies for ETFs.
Chairman Reed. So it would be within the purview--Ms.
Rominger, this would be in the purview of the SEC in terms of
this whole issue of settlement?
Ms. Rominger. The issue of fails to deliver is definitely
in the purview of the SEC. Late in 2008, the SEC did put in
place rules that required close-outs early on the fourth
trading day following settlement, and a bit longer for bona
fide market makers. There was a study done by a group within
the SEC that was in a memo on the SEC Web site published this
April that indicates in the period of time since late 2008 when
that Rule 204 was passed until April, during that time period,
fails to deliver had declined quite substantially across all
equity securities, including ETFs. The decline in fails to
deliver was about 76 percent. So that was quite a substantial
decrease. So it was taken very seriously. We continue to take
it seriously, but that rule did seem to have some desired
Chairman Reed. Well, let me follow up, Ms. Rominger, with
this. The Financial Stability Oversight Council indicated that
liquidity to counterpart exposure risk emanating for foreign
domiciled ETFs could spill over to domestic institutions or
markets, and how are you dealing with that potential spillover?
Ms. Rominger. Well, I noted that the Financial Stability
Oversight Council devoted two pages of their annual report this
year to the issue of ETFs and to the need to study further
potential systemic risks posed by ETFs. So it is something that
we are studying very closely. As you know, our Chairman is a
member of the Council, and so it is part of our study.
Chairman Reed. Let me ask just a final question, and this
goes to--perhaps touches on a lot of what we have discussed
today, and that is sort of the role of the market and the
participants in the markets. I think we all started out, at
least, I say I started with the simple notion that the markets
were created to allow companies to raise capital and investors
to be able to make investments in these companies and see the
benefits both to the company and the investor. There is always
the possibility, suspicion, whatever, that the markets have
changed and now they are operated to benefit not the companies
or for the investors, but for the traders and for the
platforms, and there are conflicts--I do not want to say that
is a conflict of interest, but certainly there are issues in
which a certain decision will favor the trading operations and
the platforms, maybe without any detriment to the investor,
maybe with a detriment.
So just your perception with respect to these ETFs, and I
will start with the SEC. Are the markets favoring one party
over the other, or are they balanced and doing what
traditionally we wanted them to do, effectively raise capital
for business growth and protect investors?
Ms. Rominger. I think both can go hand in hand. I think
that if we have markets that offer--if products are offered
that are transparent, that can trade in markets that earn the
confidence of investors, I think that the principle of investor
protection, which, of course, is paramount and very, very
important, but I think it goes hand in hand with facilitating
capital formation, because I think that to the extent that
investors can feel confident in the markets in which they are
going to invest, they will be much more willing to commit their
capital to companies and to new businesses.
Chairman Reed. Mr. Noll.
Mr. Noll. Yes. We think capital formation is critical. I
mentioned in one of my answers to your earlier questions about
the issues that I thought surrounded capital formation. I think
those things need to be addressed and I think it is incumbent
on us as market operators and regulators to work on fixing
those. I do not think that ETFs are the problem there. I think
other things are the problem there.
I also think that markets operate best when we do not try
to figure out what our investors want to do, but when we make a
fair, transparent marketplace where all investors can achieve
their goals or attempt to achieve their goals by making their
investment decisions. I am not smart enough to figure out what
Investor A, B, C, what is the right way for him to own a stock
or what is the right exposure for him to happen. What I hope I
am smart enough to do is to operate a platform where he can
achieve those ends by making his own investment decision.
So I think when we talk about reforming the marketplace or
worrying about a particular product, I think we have to be very
careful that we are not trying to pick a style of investment
that says, this is the right way and this is the wrong way. I
think that individuals, institutions, other investors have
unique ways that they approach the marketplace and it is up to
us to operate a marketplace that is fair and open and
transparent for those decisions to be executed in but not to
decide how the customer should do those.
Chairman Reed. Noel.
Mr. Archard. Yes, I would agree. I mean, fair and efficient
marketplaces is what leads to capital formation. It is what
leads to investments and the ability to grow your wealth over
I think it is very important--you know, a lot of the great
questions that have been thrown to this panel and in some cases
answered over this last hour, we need to get past some of the
anecdotes and into the real data. When I think about fair and
efficient markets, I will go back to even the settlement
question, and Eric made the good point that we are not hearing
this from clients. We do not hear it from our clients. We have
not heard from FINRA or the SEC that the settlement issue is a
But I think what is a problem is we had a reference to Reg
NMS and Rule 204. Market makers get to settle T-plus-six for a
closeout versus T-plus-three. That is not reflected in the
reporting. We have no way to know if the fail to deliver is
part of normalized market making activity, meaning that markets
are efficient and working the way that they should within the
regulatory constructs, or if there is some other issue at play.
We need to get to the heart of that and eliminate the
anecdotes, because the worst thing we could do, in my view, is
take selection out of the marketplace for products that have
produced cost efficiencies and transparency for investors.
Chairman Reed. Mr. Bradley.
Mr. Bradley. So, Senator Reed, I would think your analysis
leading into this question, I would very much concur with.
There was a point of view that I think I heard. For 20 years,
though, I have been involved in sponsoring many changes to the
capital markets, and I have testified on Capitol Hill four
times in relation to the mutualization of stock exchanges,
electronic trading and its effectiveness for institutional
traders and for retail and major changes there. All of those
things have led to outcomes that I expected in terms of lower
costs for investors.
But whenever we replace transparency and things like
exchange ownership and alignment of interests, we spin up
something new that is gray and cloudy over to the side that it
is really hard to figure out, no matter how much experience you
Trading and settlement and market maker exemptions, to me,
market maker exemptions are an old time, when stocks used to go
around on paper, on bicycles on Wall Street, and pneumatic
tubes that went from the tenth floor to the sixth floor. Those
days are gone, and yet we still give market makers exemptions
for what purpose? To me, that is where you start to tilt the
balance in some of these activities.
Our view at Kauffman, my view personally, is these products
are creating markets that are increasingly hostile to companies
that would choose to list. The economy is--you know, it is not
the only thing, but I do believe we need to do something, as
Mr. Noll suggested, to allow for small companies to come public
without all of the obligations attached that an Enron should
have had attached.
So with that, I think that would be my--oh, the last
comment. They are talking about improvements. Seven percent of
all ETF value traded fails. Point-six percent of all common
stocks traded fail. That, to me, suggests a pretty big market
Chairman Reed. Well, thank you very much. I want to thank
you all for what is a very insightful and informative hearing
on an issue that is not only timely, but rather complex.
This will not be the last that we talk about ETFs or other
products, but it is, I think, a very good way to begin our
consideration, or continue our consideration. We have
highlighted a number of issues about ETFs, their structure. We
suggested some of the complicating issues as they become more
sophisticated with leverage or with derivatives support rather
than with the basket of the stocks that they are supposedly
tracking. Frankly, I think, if we--and I will put a plug in for
my favorite organization-to-be, the Office of Financial
Research--if we had such an organization looking analytically,
as you said, Noel, about some of these issues, I think we would
be better served.
My colleagues may have written statements or questions,
which I will ask them to submit no later than next Wednesday,
October 26, and then we would ask you, if there are questions,
to respond as quickly as possible, I would hope within a week
if you could do that.
Again, your written testimony is completely made part of
the record and we thank you very much for an informative
discussion and I am sure we will continue the discussion going
With that, I will adjourn the hearing. Thank you.
[Whereupon, at 10:56 a.m., the hearing was adjourned.]
[Prepared statements and responses to written questions
supplied for the record follow:]
PREPARED STATEMENT OF EILEEN ROMINGER
Director, Division of Investment Management, Securities and Exchange
October 19, 2011
Chairman Reed, Ranking Member Crapo, Members of the Subcommittee:
My name is Eileen Rominger, and I am the Director of the Division
of Investment Management at the Securities and Exchange Commission. I
am pleased to testify on behalf of the Commission on the topic of
exchange-traded funds, or ``ETFs,'' as they are commonly known.
ETFs are a type of exchange-traded product or ``ETP'' that must
register as investment companies. The SPDR or ``spider'' ETF, which
tracks the S&P 500 stock index, was the first ETF and is still one of
the largest on the market. Since their inception in the 1990s, ETFs
have become increasingly popular as a type of investment vehicle. With
investors ranging from institutional to retail, there has been a
proliferation of these types of funds in the marketplace.
ETFs in the United States have grown to account for approximately
$1 trillion in assets, or approximately 10 percent of the long-term
U.S. open-end investment company industry, with U.S.-domiciled ETFs
making up approximately two-thirds of global offerings. \1\ As ETFs
gained in popularity, ETPs expanded from ETFs tracking equity indexes
into the development of a variety of ETPs, including those based on
fixed-income instruments, commodities, currencies, and foreign
securities. This product development also has generated increasingly
complex structures, such as leveraged, inverse, and inverse leveraged
ETFs. Because of the growth and development in such ETFs and ETPs, the
Commission has been actively following, and continues to engage in the
analysis of, these products.
\1\ See, Financial Stability Oversight Council Annual Report 2011
at 66, available at http://www.treasury.gov/initiatives/fsoc/Documents/
My testimony will provide a general overview of ETPs and the SEC's
roles with respect to these products. It also will discuss recent
developments in the markets regarding ETFs, including their market
impact. The testimony will conclude with a summary of the SEC's current
efforts in this ever growing and evolving market.
Overview of Exchange-Traded Products
ETPs, of which ETFs are one type, seek to provide investors
exposure to a specific benchmark or investment strategy by investing in
securities and other assets. ETPs are issued by entities organized in a
variety of different legal forms, including as ETFs registered as
investment companies under the Investment Company Act of 1940 (1940
Act) which register their securities for the offer and sale to the
public. ETPs also can be offered and sold publicly as interests in
trusts and commodity pools, or exchange-traded notes issued by public
companies, which are not registered as investment companies. However,
all offerings of ETP securities, whether or not the ETP entity is
registered under the 1940 Act, are registered under the Securities Act
of 1933 (Securities Act), and the securities are listed for trading on
a national securities exchange. Some of the more popular types of ETP
securities trading in the marketplace include the following:
1. ETFs that are registered under the 1940 Act as open-end management
investment companies or as unit investment trusts. ETFs offer investors
an undivided interest in a pool of securities and other assets. There
are two basic types of ETFs: (1) index-based ETFs; and (2) actively
Index-Based ETFs. Most ETFs trading in the marketplace are index-
based ETFs, which seek to track an underlying securities index by
achieving returns that closely correspond to the returns of that index,
before fees. This type of ETF primarily invests in equity or fixed-
income securities issued by the companies that are included in the
index or a representative sample of those securities. For example, the
SPDR fund invests in equity securities of all of the companies
contained in the S&P 500 stock index.
Today, there are approximately 984 index-based ETFs registered
under the 1940 Act with about $900 billion in assets. There are
approximately 24 providers or advisers who sponsor index-based ETF
shares. The shares of these ETFs are primarily listed on NYSE Arca and
NASDAQ. Leveraged, inverse and inverse leveraged ETFs, which are
discussed below, generally are considered index-based ETFs because they
track a securities index.
Actively Managed ETFs. The first actively managed ETF was approved
in 2008. While there are fewer actively managed ETFs than index-based
ETFs trading in the marketplace today, there has been an increase in
new actively managed ETFs over the past few years. Actively managed
ETFs are not based on an index. Rather, they seek to achieve a stated
investment objective by investing in a portfolio of securities and
other assets. This type of ETF is actively managed because, unlike an
index-based ETF where the components of an index are relatively static,
an actively managed fund adviser may buy or sell components in the
portfolio on a daily basis, provided such trades are consistent with
the overall investment objective of the fund. To address transparency
concerns, actively managed ETFs are currently required to publish their
holdings daily. Because there is no underlying index that can serve as
a point of reference for investors and other market participants as to
the fund's holdings, disclosing the specific fund holdings ensures that
market participants have sufficient information to engage in the
arbitrage, described below, that works to keep the market price of ETF
shares close to the net asset value (NAV) of the fund or portfolio.
Currently, there are approximately 35 actively managed ETFs with
about $6 billion in assets. There are approximately five providers or
advisers who sponsor these types of ETFs. The shares of these ETFs are
also primarily listed on NYSE Arca and NASDAQ.
2. ETPs issued by entities such as trusts and other pooled vehicles,
such as commodity pools. ETPs that are not based on securities and
whose portfolios may consist of physical commodities, currencies, or
futures are created, redeemed, and traded on a national securities
exchange in a manner similar to ETFs, but the entities offering the
ETPs are not registered or regulated as investment companies under the
3. Exchange traded notes or ``ETNs,'' which, unlike interests in ETFs,
generally are unsecured debt securities issued by public companies, in
most cases by bank holding companies or investment banks. ETNs also are
exchange-traded securities that can provide the investor with
investment exposure to certain market benchmarks or strategies. As ETNs
are debt obligations of the issuer of the security, the ETN does not
provide the investor with any ownership interest in the referenced
security or securities in the referenced index. In addition, an
investor in an ETN is exposed both to the market risk of the linked
securities or index of securities and the credit risk of the issuer.
ETNs do not share the same fund-like or trust-like structure as do
other ETPs, and are not registered or regulated as investment companies
under the 1940 Act. \2\
\2\ ETNs, which are debt securities that track the performance of
an underlying benchmark index, asset, or strategy, are generally not
redeemable by the holder, unless the terms of the particular series of
ETNs permit the holder to do so. There are no Authorized Participants
(as described herein) for ETNs, and because ETNs do not hold portfolios
of securities or other assets, the same arbitrage opportunities
available for ETFs are not applicable to ETNs.
Although this testimony will focus primarily on ETFs, some of the
structures, features, and trading characteristics of ETFs, as well as
the issues and concerns discussed below also apply to other ETPs.
Structure and Features Unique to ETFs
ETFs combine features of a mutual fund, which can be purchased or
redeemed at the end of each trading day at its NAV per share, with the
intraday trading feature of a closed-end fund, whose shares trade
throughout the trading day at market prices that may be more or less
than its NAV. A fundamental difference between ETFs versus mutual funds
is that ETFs do not sell individual shares directly to, or redeem their
individual shares directly from, all investors. Instead, ETF sponsors
enter into relationships with one or more financial institutions that
become ``Authorized Participants'' for the ETF. Authorized Participants
are typically large broker-dealers. Only Authorized Participants are
permitted to purchase and redeem shares directly from the ETF, and they
can only do so in large aggregations or blocks (such as 50,000 ETF
shares) commonly called ``Creation Units.'' The value of the Creation
Unit could range from hundreds of thousands of dollars to several
Creation Unit purchases and redemptions are typically in-kind,
although cash transactions may be permitted for certain ETFs or under
certain prescribed circumstances. To create ETF shares in-kind, an
Authorized Participant assembles and deposits a designated basket of
stocks with the fund, and in return, receives ETF shares from the fund.
Once the Authorized Participant obtains the ETF shares, it is free to
sell the ETF shares into the open secondary market, either to
individual investors, institutions, or market makers in the ETF. The
redemption process is simply the reverse. An Authorized Participant
buys a large block of ETF shares on the open market and delivers the
shares to the fund; in return, the Authorized Participant receives a
predefined basket of individual securities, or the cash equivalent.
Like operating companies or closed-end funds, the offerings of the
shares of ETFs are registered under the Securities Act, and a national
securities exchange lists the ETF shares for trading. As with other
listed securities, investors also may trade ETF shares in off-exchange
transactions. In either case, ETF shares trade at negotiated prices.
The development of the secondary market in ETF shares depends upon the
activities of market makers and interest from individual investors,
traders, and institutional investors. Individual investors may dispose
of ETF shares by selling them in the secondary market at the market
price, which may be higher or lower than the NAV of the shares, and
paying customary brokerage commissions on the sale.
However, ETFs are structured in a way that seeks to minimize the
potential for their shares to trade in the secondary market at a
significant premium or discount in relation to their intraday NAV. This
is a result of the arbitrage opportunities inherent in the ETF
structure. Depending on the liquidity of the underlying securities or
assets, market volatility, supply and demand, and other factors,
whenever the price of an ETF diverges from the NAV of its underlying
components, market participants have an opportunity to buy the cheaper
of the ETF or its underlying components, and sell the more expensive of
the two. Market participants who are Authorized Participants, or who
have agreements with Authorized Participants, can lock in this
arbitrage profit by creating or redeeming ETF shares at the end of the
day, thereby offsetting their exposure in the underlying components.
For example, with respect to a simple U.S. equity index-based ETF,
if the price of the underlying stocks comprising the index is below the
price of the ETF shares, a market maker who is an Authorized
Participant can buy the underlying stocks and short the ETF. Then, at
the end of the day, the Authorized Participant can buy shares of the
ETF in-kind through the creation process using the underlying stocks
purchased earlier in the day. In return, the Authorized Participant
receives shares of the ETF that can be delivered against the short ETF
The creation/redemption process therefore serves as the basis for
the arbitrage mechanism that provides market participants with an
incentive to buy or sell shares of the ETF whenever sufficient
divergence between the market price of the ETF and the NAV of the
underlying components occurs. To further aid in the process, an
estimated NAV, also referred to as the ``intraday indicative value,''
is disseminated at least every 15 seconds throughout the trading day.
Differences Between ETFs and Mutual Funds
ETFs differ from mutual funds. For example, on average, operation
and management fees for ETFs historically have been less than those for
index mutual funds. ETFs generally disclose their holdings every day in
addition to the quarterly disclosure required for all funds. ETF shares
are listed and traded on exchanges and can be bought or sold at market
prices at any time of the trading day. Mutual funds shares are
available for purchase and redemption in transactions with the funds at
their daily calculated closing NAV per share. Lastly, ETFs can be more
tax efficient than mutual funds because ETF shares are generally
redeemable ``in-kind,'' which can limit the potential for incurring
taxable gains. Not all ETFs have been more tax efficient, however.
Regulation of Exchange-Traded Products: Roles of SEC Divisions and
An ETF, as an investment company, must file a registration
statement with the Commission under the 1940 Act and register the
offering of its shares under the Securities Act. In addition to
registering under the 1940 Act, under existing regulations, the ETF
must rely on an order, typically issued to the ETF's sponsor, giving
relief from certain provisions of the 1940 Act that would not otherwise
allow the ETF structure. The SEC issued the first order to an ETF
organized as a unit investment trust in 1992, and began issuing orders
to ETF sponsors for ETFs organized as open-end funds in 1996. The SEC
now has issued more than 100 orders on which ETF sponsors rely to
launch their ETFs.
As discussed above, while ETFs are typically registered with the
SEC as investment companies, there are other ETPs that do not hold
securities, but instead hold commodity- or currency-based assets and,
therefore, are not subject to the provisions of the 1940 Act. The
issuers of these ETPs register the public offerings of their securities
with the Commission under the Securities Act and become subject to the
periodic reporting requirements of the Securities Exchange Act of 1934
In addition, the sponsor of a new ETP, including ETFs, generally
must receive relief from certain provisions of the Exchange Act.
Moreover, in order for an exchange to list and trade a new ETP,
depending on the type of ETP, the SEC must review and approve the
exchange's listing proposal pursuant to specific requirements under the
Exchange Act. Further, the ETP must comply with the initial and
continued listing requirements of its listing exchange.
Securities Act--Review of Registration Statements
The Commission staff's review of filed registration statements,
including those involving public offerings of securities of trusts and
commodity pools, is for the purpose of ensuring complete disclosure.
The Securities Act registration provisions require ``full and fair
disclosure'' afforded by registration with the Commission and delivery
of a statutory prospectus containing information necessary to enable
prospective purchasers to make an informed investment decision.
Investors in these registered securities offerings have civil remedies
to protect them from materially deficient disclosure (material
misstatements and omissions) in registration statements and
prospectuses as well as the protections of the antifraud provisions of
the Federal securities laws, and the Commission's enforcement efforts.
As applied to ETPs generally, the Securities Act requirements
relate primarily to disclosures made by the entity issuing the
securities, including disclosures about the issuer, the securities
being issued, and material risks affecting the investment.
Registration and Exemptions Under the 1940 Act
ETFs that meet the definition of ``investment company'' under the
1940 Act must register as investment companies under that Act and are
subject to the Commission's examination authority. Typically, an ETF
meets the definition of ``investment company'' because it primarily
invests in securities, as opposed to physical commodities or
currencies. ETFs, as investment companies, are subject to the
regulatory requirements of the 1940 Act, as well as to the terms and
conditions of the exemptive relief necessary to operate under the 1940
Act. Together, the requirements of the 1940 Act and the relevant
exemptive relief apply regulatory requirements designed to protect
investors from various risks and conflicts. For example, ETFs, like
other investment companies, are required to follow strict limitations
on their use of leverage and transactions with affiliates. In addition,
they are subject to specific reporting requirements and disclosure
obligations relating to investment objectives, risks, expenses, and
other information in their registration statements and periodic
reports. Further, with few exceptions, ETFs are subject to oversight by
boards of directors and are operated by an investment adviser
registered under the Investment Advisers Act of 1940.
Exchange Act Listing Requirements
The Federal securities laws also require a national securities
exchange to have rules governing the listing and trading of securities
on its markets. With respect to some types of ETPs, such as index-based
ETFs, an exchange may list and trade their shares without separate
Commission approval, provided the ETP satisfies each of the initial and
continued listing criteria applicable to that category of product. Such
listing criteria, which are generally referred to as ``generic listing
standards,'' must already have been approved by the Commission. Much of
the specific quantitative and qualitative generic listing criteria
pertain to the individual and collective components comprising the
underlying index and include provisions relating to minimum market
value (or principal amount outstanding), minimum trading volume,
minimum diversification, minimum number of components, and net worth of
the issuer. The exchange is required to file a form with the Commission
to notify the Commission that the product is listed and trading and
represent that such product complies with all of the applicable generic
To be able to list and trade an ETP for which the Commission has
not approved ``generic listing standards,'' such as actively managed
ETFs, commodity-based trust-issued receipts and commodity pools, the
exchange must file a proposed rule change with, and obtain approval
from, the Commission prior to being able to list and trade the product.
The Commission publishes such proposals for notice and public comment.
To approve such a proposal, the Commission must determine that the
proposed rules are, among other requirements under the Exchange Act,
designed to prevent fraudulent and manipulative acts and practices, to
promote just and equitable principles of trade, to remove impediments
to, and perfect the mechanism of a free and open market and, in
general, to protect investors and the public interest. In its analysis,
Commission staff considers the structure and description of the
product, its investment objective, investment methodology, permitted
investments, and the availability of key information and values,
including the NAV, intraday indicative value, and the disclosed
portfolio of securities and other assets. In addition, Commission staff
closely reviews the valuation methodology of the securities and other
assets that would comprise the portfolio, the circumstances in which
the exchange may, or will, institute a trading halt in the shares,
representations regarding the adequacy of exchange surveillance
procedures, and the dissemination of information circulars relating to
An issuer of a new ETP must also obtain relief from certain
provisions and rules of the Exchange Act before the shares can be
traded on an exchange. The relief relates to provisions of the Exchange
Act that pertain to, among others, lending on new issue securities,
customer disclosure requirements, Regulation M, as well as certain
notice and tender offer requirements.
Compliance and Enforcement of the Federal Securities Laws
The Commission's Office of Compliance Inspections and Examinations
(OCIE) periodically inspects and examines SEC-registered investment
advisers, broker-dealers, and exchanges in connection with issues
related to ETFs and, as appropriate, ETPs, and examines issuers of ETPs
that are also registered as investment companies. For registered ETFs
and investment advisers, the staff examines the adequacy of internal
controls and the effectiveness of the compliance structure. In
addition, the staff may examine specific operations of registered ETFs
and certain ETPs managed by registered investment advisers, such as the
portfolio trading, execution, and investment decision-making processes.
Furthermore, the staff reviews broker-dealers that sell ETPs to retail
customers and that act as Authorized Participants. Broker-dealer
examinations, conducted by OCIE and the Financial Industry Regulatory
Authority (FINRA), typically review suitability, appropriate
disclosure, and supervision of sales. Broker-dealers' trading practices
are also reviewed to assess compliance with securities regulations.
OCIE staff also conducts inspections of exchanges' initial and
continued listing compliance programs and market surveillance that may
include issues related to ETPs.
The Commission's Division of Enforcement investigates allegations
of misconduct concerning ETPs by market participants. Such misconduct
could include inadequate or misleading disclosures in ETP offering
documents and marketing materials, as well as insider trading or
improper sales practices involving ETPs. Within the Division of
Enforcement, newly created specialized Units work closely with the
Commission's other Divisions and Offices to evaluate existing and
emerging risks to investors in the ETP marketplace. A continuing focus
of the Units is whether ETPs--as they reflect new investment strategies
and grow in popularity--are being marketed and sold to investors with
appropriate disclosures and in accordance with the duties and
responsibilities owed to investors by industry participants.
The Commission recently instituted enforcement proceedings against
a former Goldman, Sachs & Co. employee and his father alleging insider
trading on confidential information about Goldman's trading strategies
and intentions that the employee learned while working on the firm's
ETF desk. The SEC's Division of Enforcement alleges that Spencer D.
Mindlin obtained nonpublic details about Goldman's plans to purchase
and sell large amounts of securities underlying the SPDR S&P Retail ETF
(XRT) and that he tipped his father Alfred C. Mindlin, a certified
public accountant. According to the complaint, father and son then
illegally traded in four different securities underlying the XRT with
knowledge of market-moving trades in these securities that Goldman
would later execute. The case marks the SEC's first insider trading
enforcement action involving ETFs.
Developments in the Markets Regarding Exchange-Traded Products
ETPs have become increasingly popular as an investment vehicle
among investors, resulting in a proliferation of these products in the
marketplace. This proliferation has been accompanied by product
innovation, giving rise to new and increasingly complex products. Below
is a summary of recent developments in this regard, as they relate to
the ever growing and evolving ETP landscape.
Leveraged, Inverse, and Inverse Leveraged ETFs
The Commission received the first application for leveraged ETFs in
2000. After consideration and review of the issues, the Commission
approved this first leveraged ETF application in 2006. To date, three
ETF providers operate leveraged, inverse, and inverse leveraged funds
registered under the 1940 Act. There are approximately 152 such
leveraged, inverse, and inverse leveraged ETFs in the market with
approximately $48 billion in assets. \3\
\3\ In addition, since 2006, sponsors have also introduced
commodity- and currency-based leveraged, inverse, and inverse leveraged
ETPs that are not registered under the 1940 Act.
Leveraged ETFs are funds that track an underlying index, but seek
to deliver daily returns that are multiples of the performance of the
index or benchmark they track. Strategies for long leveraged ETFs are
employed by investing in securities or other assets, as applicable,
contained in underlying indices and leveraged derivative instruments,
such as total return swaps, futures contracts and options. Inverse ETFs
(also called ``short'' ETFs) seek to deliver the opposite of the
performance of the index or benchmark they track. Like traditional
ETFs, some leveraged and inverse ETFs track broad indices, some are
sector specific, and other ETFs are linked to commodities, currencies,
or some other benchmark. Inverse ETFs have been marketed as a way for
investors to profit from, or at least hedge their exposure to, downward
moving markets. Inverse leveraged ETFs seek to achieve a return that is
a multiple of the inverse performance of the underlying index. An
inverse ETF that tracks a particular index, for example, seeks to
deliver the inverse of the performance of that index, while a 2x
inverse leveraged ETF seeks to deliver double the opposite of that
index's performance. Strategies for inverse leveraged ETFs are also
accomplished by investing in the leveraged derivative instruments
mentioned earlier, which enables the funds to pursue objectives without
selling short each of the securities included in the underlying index.
While the portfolio composition for long leveraged ETFs generally
includes a mix of stock or other assets, as applicable, including total
return swaps, cash, and futures contracts, inverse leveraged ETFs'
portfolios are generally composed entirely of total return swaps,
futures, and cash or cash equivalent securities.
Most leveraged, inverse, and inverse leveraged ETFs ``reset''
daily, meaning that they are designed to achieve their stated
objectives on a daily basis. Their performance over longer periods of
time--over weeks, months, or years--can differ significantly from the
performance (or inverse of the performance) of their underlying index
or benchmark during the same period of time. This effect can be
magnified in volatile markets. An ETF that is set up to deliver twice
the performance of a benchmark from the close of trading on Day 1 to
the close of trading on Day 2 will not typically achieve twice the
weekly, monthly, or annual return of that same benchmark.
Observations and feedback from market participants suggest that
some investors may not fully understand the daily performance features
of leveraged, inverse, and inverse leveraged ETFs, and the consequences
of holding the shares of such ETFs over extended periods. To help
address this issue, the Commission, together with FINRA, has issued
guidance and other information to alert investors and other market
participants of the risks of holding such ETF shares for a period of
more than one day.
Separately, and for the reasons discussed further below, in March
2010 Commission staff determined to defer consideration of exemptive
requests for those products that fall under the 1940 Act that would
permit the launch of new ETFs making significant investments in
derivatives. Because leveraged and inverse leveraged ETFs often make
significant use of derivatives, deferring consideration of exemptive
requests related to derivatives necessarily deferred the issuance of
new orders permitting leveraged and inverse ETFs that would be subject
to the 1940 Act.
Certain Complex ETPs and Actively Managed Fixed-Income ETFs
In recent years, the types of ETPs introduced to the marketplace
have become increasingly complex. For example, some ETPs, in the form
of commodity-based trust-issued receipts, seek to track an index of
futures on volatility of a portfolio of stocks, such as the S&P 500.
Futures on volatility have added another dimension to the calculation
to express future or expected volatility. In addition, the Commission
has witnessed an increase in the past few years in the variety of
actively managed ETFs introduced by sponsors. For example, while an
assortment of actively managed ETFs based on fixed-income portfolios is
listed and trading in the marketplace, there have been an increasing
number of actively managed ETFs that seek to primarily invest in
instruments that raise concerns with respect to liquidity and
transparency, including emerging market debt securities, high-yield
debt securities, and other instruments. Commission staff is currently
engaged in a review of these and other types of portfolios (such as
those that hold illiquid, nontransparent or other types of investments)
to determine whether the underlying instruments meet minimum liquidity
and other thresholds, for purposes of transparency, fair valuation, and
efficiency in the arbitrage process.
Recent reports have revealed a growth of ``synthetic'' pools with
traits similar to U.S. domiciled ETFs (European-domiciled ETFs)
investing in derivative assets in Europe and Asia. While such reports
indicate that nearly half of European-domiciled ETFs synthetically
replicate the underlying index using swaps and other derivatives, only
about 3 percent of total U.S.-domiciled ETF assets are synthetic,
mostly through leveraged, inverse, and inverse leveraged ETFs. \4\
Synthetic ETFs have experienced limited growth in the United States
partly because regulatory standards under the 1940 Act limit the use of
derivatives to replicate underlying indexes. In addition, as already
mentioned, in March 2010, pending a review of current practices,
Commission staff limited the ability of new ETF sponsors to introduce
ETFs that would make significant investments in derivatives. Together,
these standards and actions have limited the ability of 1940 Act-
registered funds to engage in derivatives-based activity and create
synthetic ETF structures. With respect to other types of ETPs that are
not registered under the 1940 Act, for example, commodity pools,
Commission staff is continuing to consider the ramifications of
significant investments in derivatives for those products, and is
evaluating whether their structures, investments, trading
characteristics, risks, benefits, and other factors, invite closer
\4\ See, Financial Stability Oversight Council Annual Report 2011
at 66-67, available at http://www.treasury.gov/initiatives/fsoc/
Impacts of Exchange-Traded Funds in the Markets
Recent evidence has indicated that, while the months of August and
September of this year have seen some very volatile days, the
securities markets have functioned in an orderly fashion, without the
types of disorderly trading that were seen on May 6, 2010. Apart from
the fact that ETFs trade intraday, most ETFs are similar to mutual
funds in that they both translate investor purchases and sales in the
fund (and changes in investor sentiment) into purchases and sales of
underlying holdings. Some ETFs, however, are structured in a way that
require the purchase or sale of underlying holdings based on movements
in the market even absent investors' purchases or sales of the ETF.
This is the case for leveraged, inverse, and inverse leveraged ETFs.
Regardless of whether or not leverage is employed, because ETFs
trade throughout the day, their prices are dynamically linked to the
prices of their underlying holdings, and the price fluctuations of
individual holdings, such as stocks, creates associated price
fluctuations in the ETF. Likewise, buying or selling an ETF affects
each of the underlying holdings.
Staff studying ETF trading that occurred on May 6, 2010, observed
that under disorderly market conditions, these linkages result in
heightened volatility of the ETFs. On that day, a large number of ETFs
traded for a short period of time with massive intraday price swings.
The shares of more than 25 percent of all ETFs experienced temporary
price declines of more than 50 percent from their 2:00 p.m. market
prices. One large ETF sponsor reported that 14 of its domestic stock
ETFs experienced executions of $0.15 or less per share (including five
ETFs that had executions of one cent or less) while also observing that
its domestic bond and international ETFs appeared to execute at
reasonable prices. Staff is continuing to examine the dynamics of ETF
trading, the arbitrage mechanisms designed to keep the prices of ETFs
close to the value of their underlying assets, and linkages (both
intended and unintended) between ETFs and the market as a whole.
For example, because ETF share prices are dynamically linked to the
prices of their underlying holdings, the trading and other
characteristics of the underlying portfolio investments, such as
certain illiquid types of securities and particular over-the-counter or
``OTC'' derivatives, may impact the arbitrage process necessary to
closely align the ETF share price with its NAV. In certain
circumstances, temporary imbalances in supply and demand might result
in the price of the ETF decoupling from the value of the ETF's
underlying instruments as the ETF starts to behave more like a stand-
alone product whose price responds solely to whatever liquidity is
immediately available in that product, regardless of the value of the
underlying investments. Under these circumstances, the ETF can begin to
trade at a significant premium or discount to the NAV of its assets.
In addition, while index-based ETFs are designed to track the
performance of their respective underlying indexes, an ETF may fail to
meet this objective over a period of time, based on investment
methodologies used and trading costs incurred. While tracking errors
may be small, such deviations could lead to inefficiencies for
institutional investors that are using ETFs to enter into large hedged
positions. Tracking performance is particularly an issue with respect
to leveraged and inverse leveraged ETFs, which promise daily returns
equal to the multiple or inverse multiple of the performance of an
underlying index or benchmark. Because leveraged and inverse leveraged
ETFs only track daily returns, the performance of the fund and the
underlying index will not correlate over extended periods of time.
As noted earlier, in March 2010, Commission staff determined to
defer consideration of exemptive requests for ETFs seeking to register
under the 1940 Act and make significant investments in derivatives.
This action was taken in light of concerns raised generally about the
use of derivatives by all registered investment companies, including
ETFs. While staff recognized that the use of derivatives is not a new
phenomenon, the staff determined that the increasing complexity of
derivatives and their growing use by funds made it the right time to
reevaluate the Commission's regulatory protections. As part of this
review, in August 2011, the Commission issued a concept release seeking
broad public comment on funds' use of derivatives and on the current
regulatory regime under the 1940 Act as it applies to funds' use of
derivatives. Although the staff recognizes the competitive impact of
the decision to defer the consideration of exemptive relief, the staff
is committed to the Commission's mission to protect investors.
Accordingly, the staff has determined not to issue any additional
exemptive relief for ETFs seeking to make significant use of
derivatives pending the broader review of the use of derivatives by all
funds. The comment period for the concept release expires on November
7, 2011. The staff looks forward to reviewing the comments that the
Commission receives and will carefully consider them in assessing how
to proceed with respect to both the use of derivatives by funds
generally and the staff's consideration of requests for exemptive
relief for derivatives-based ETFs.
In addition, these initiatives with respect to ETFs have informed
the staff with respect to ETPs more generally. As a result, Commission
staff from across multiple Divisions and Offices is currently engaged
in a general review of ETPs, which includes gathering and analyzing
detailed information about specific products. For example, Commission
staff is currently engaged in a general review of ETPs in connection
with, among others, the adequacy of investor disclosure, liquidity
levels and transparency of underlying instruments in which ETPs invest,
fair valuations, efficiency in the arbitrage process and the
relationship between market volatility and ETPs.
In conclusion, ETPs have grown significantly since the early 1990s
as they have grown in popularity with both institutional and retail
investors. As ETPs have proliferated, they also have grown in
complexity. The SEC has a corresponding interest in making sure that
investors receive information about these products that permit them to
make informed decisions. Also, because of the growth and innovation in
such products, the Commission has been actively following, and
continues to engage in the analysis of, these products.
PREPARED STATEMENT OF ERIC NOLL
Executive Vice President Transaction Services, NASDAQ OMX
October 19, 2011
Thank you Chairman Reed and Ranking Member Crapo for the invitation
to speak to you today about an important category of financial
products--Exchange Traded Products (ETPs). \1\ Nasdaq OMX lists and
trades these products and partners with the Financial Industry
Regulatory Authority (FINRA) to ensure quality regulation and
protection of investors. We also applaud the important work by the
Securities and Exchange Commission (SEC) to establish the listing and
trading environment that has led to a competitive and innovative
environment for these products.
\1\ The majority of this testimony concerns the broad and diverse
group of Exchange Traded Products (ETPs), including Exchange Traded
Funds (ETFs). Sections on market activity and risk narrow the
discussion to ETFs because they have the best available data and make
up the vast majority of equity ETPs.
As we examine these issues we should recall that these products
have done a lot of good for a lot of investors since they were first
developed almost 20 years ago: they have reduced the cost of investing
in equities; they have reduced the risk of equity investment and
broadened the tools to hedge risk; they have often been the way many
Americans have begun successfully investing.
In fact, taken as a whole, ETPs are one of the greatest financial
innovations of our time and offer great value to retail and
institutional investment communities. ETPs offer transparency,
liquidity, diversification, cost efficiency and investment flexibility
to gain broad market exposure or to express a directional view as a
core or satellite component to one's investment portfolio. ETPs do so
while offering investment exposure to all asset classes--many of which
would otherwise be inaccessible.
We at NASDAQ OMX are aware of the recent cautionary calls by some
industry experts and regulatory groups about ETPs who are rightly
applying a presumption of doubt and scrutiny to all financial matters
that might harbor systemic risks for our post 2008 economy. Evaluation,
understanding and debate about these issues is healthy and we welcome
the chance to comment on systemic risks arising from ETPs, how we view
their contribution to the markets/investors and some emerging
international issues. At NASDAQ we aim to be the champion of ETP
transparency as it relates to the underlying indices, listing and
trading the products and the dissemination of ETP related data.
A word about our listing standards: they are developed in a
completely transparent manner with full public comment and SEC
approval; at NASDAQ we focus on the key issues for investors, like
ensuring the financial strength of the issuers and specifying the
components of the products. And, of course, we have the people and
tools to monitor compliance with these rules on a continuous basis.
These are volatile times in our markets. In difficult times it is
natural to look for a cause that can be easily identified and even
fixed. ETPs are a tempting target. But restricting or eliminating the
ETP business will not solve the sovereign debt crisis in Europe, will
not balance the U.S. budget, will not restore bank balance sheets, will
not add jobs, and will not repay consumer debt and get them spending
again. There are very large, very real uncertainties that are driving
global financial market volatility.
In fact, ETPs provide investors with very valuable diversification,
hedging and risk management opportunities. For those reason ETPs have
grown rapidly in popularity over recent years and it is not uncommon
for trading in ETPs to increase on volatile days. What is interesting
is that even for the largest ETPs, their proportion of overall trading
is relatively stable in proportion to trading in the underlying stocks.
ETPs, particularly equity based ETFs, also benefit listed
companies. By being included in a single, diversified security
companies gain access to a greater audience of investors who may not
have bought the individual stock. And, of course, this means that the
markets are deeper and more liquid, benefiting not only investors but
the economy as a whole.
Prices of ETFs fluctuate with changes in the value of the
underlying stocks and with changes in supply and demand for the ETF
itself. These two prices are kept in line by market makers who trade
the ETF, the underlying stocks, and can create and redeem units of the
ETFs as more or fewer are demanded by investors. All of these
activities are rules based, entirely transparent, and mostly occurring
on exchanges and other transparent institutions.
It is really hard to overuse the word ``transparent'' when talking
about ETPs. That is why some investors prefer them over other similar
products, like mutual funds. Mutual funds and ETPs play different roles
in an investor's portfolio, but ETPs low cost and transparency make
them an important category that should remain widely available.
As I mentioned at the outset, it is important to understand that
ETPs already have an established history of functioning within the
markets. The first modern ETF was introduced in 1993, and NASDAQ OMX
launched its transformative QQQ equity index based ETF in 1999. Our
flagship ETF, the QQQ has been the home for millions of investors who
want to invest in the NASDAQ 100 index--the top 100 NASDAQ listed
nonfinancial companies--a proprietary index of our category defining
companies like Apple, Microsoft, Cisco, Staples, Dell, Qualcomm, and
others. The QQQ is one of the most widely recognized and traded
securities in the world. I can tell you from personal experience that
the companies that make up QQQ consider it a real achievement, and
certainly NASDAQ is proud of the excellence QQQ represents.
Since these products were first introduced, innovations have
propelled them from simple indexes on a basket of stocks, ETFs, to a
host of other ETPs that approach complex financial strategies for
investors. Even some of the names of these ETPs suggest diversity or
even complexity--commodity ETPs, currency ETPs, leveraged ETFs and even
inverse leveraged ETFs.
As of September 30, 2011, according to BlackRock's most recent ETF
Landscape Report, there were over 4,000 Exchange Traded Products listed
globally, of which 1,335 were listed in the United States representing
assets of $1.4 trillion and $969 billion respectively. Of the 1,335
products listed in the United States 83 are listed on NASDAQ OMX;
however, all domestic ETPs are actively traded to varying degrees on
the suite of NASDAQ OMX domestic exchanges--including PSX and NASDAQ
Moreover, NASDAQ trades almost 23 percent of ETF dollar volume
representing an average of over 350 million shares and $21 billion per
day. Additionally, our Nordic exchange list and trade 69 ETPs in
The proliferation of ETPs as an investment vehicle and growth of
the assets in ETPs has happened more quickly than the needed broader
education about the products and their structures to investors,
regulators, academics, and policy makers. This growth resulted from
investors enthusiastically embracing exchange traded products for the
aforementioned benefits; with a consequence that some have formed
incorrect assumptions (in many cases even by those in the investment
community). Among the most relevant of those assumption is that all
ETPs are constructed the same and are based on and track an underlying
index. This isn't the case, but that does not infer that the product
category is not beneficial to the marketplace and investment community.
Innovation has allowed ETPs to adapt from ETFs tracking baskets of
domestic equities to more sophisticated products, in some cases holding
derivatives and/or using leverage as a tool of the product's investment
objective. These new products add value in that they offer new and
quite unique exposure to the markets. This, however, does not imply
that all products are meant for all investors. Investor education and
disciplined application of suitability standards for any prospective
holder of a product will continue to be paramount as ETP numbers grow
and the investment objectives continue to expand.
ETPs and Market Risk
We believe that ETPs are of limited concern when evaluating them in
the context of whether they are a potential culprit in future
situational analysis of systemic risks to our financial system. While
activity in ETPs can generate corresponding transactions in the
underlying securities, ETPs pale in comparison with other financial
Further, some have tried to use the extraordinary trading
environment we have experienced over the last year to connect ETP
activity with some chaotic trading days. We think these analyses ignore
the unparalleled uncertainty that the market must process during the
fast paced news and information cycle of every trading day. From
rolling flirtations with debt and sovereign failure in Europe, to
potential Government debt payment interruptions in the U.S., to a
global demand curve for goods, services and human capital that no one
can accurately determine our markets are simply trying to rationalize
and apply metrics to far too many unknowns. ETPs do not cause this,
they, like other asset classes are just trying to move within this
We had our economic research team look at trading in ETFs on normal
and volatile days. Trading in ETFs varies roughly in proportion with
overall trading in the market. When news breaks and market prices move
trading volume increases in both the ETFs and the underlying stocks.
The largest ETFs track the S&P 500 index. As a group they trade
about $40B worth of volume each day (July-September 2011). Though
large, that is a relatively small amount of trading when compared to
the $125B traded daily in the underlying 500 stocks that make up the
On very volatile trading days, such as those that occurred in early
August of this year, trading in both the ETFs and the underlying stocks
increases. Because many investors manage their market risk using the
ETFs, trading in ETFs rises slightly more on a percentage basis than
trading in the underlying. This is not surprising considering the
convenient risk management opportunity provided by ETFs.
In a broader index, such as the Russell 2000, ETFs provide even
greater benefits to investors. Buying a single security is far easier
than 2000 often less liquid ones. For that reason, it is not surprising
that ETFs based on the Russell 2000 trade more relative to the
underlying. Average daily dollar volume for the Russell 2000 ETFs is
about $7B. Average daily dollar volume in the underlying 2000 stocks is
about $15B. On volatile days in August 2011 the Russell 2000 ETFs
traded over twice as much as on a normal day ($16B on August 9, 2011)
while the underlying stocks did not quite double in dollar volume ($27B
on August 9, 2011).
Within the day, ETF volume fluctuates along with volume of the
underlying stocks. Late in the day, trading of the stocks underlying
the index increases disproportionately, as many investors and traders
adjust their exposure near the end of the day. Trading in the ETF is
relatively less active late in the day.
Within the day, the Russell 2000 ETFs often trade in dollar volumes
approaching the amount traded in the underlying 2000 stocks. Again,
this is not surprising considering the benefit offered investors of
being able to control their exposure to this large index of relatively
small companies with a single instrument. Like the wider index, trading
in the underlying components increases significantly at the end of the
day, reflecting many investors and traders attempting to buy or sell
the individual stocks near the official closing price. Late in the day
trading in the ETF itself increases less than the component stocks.
The trading patterns we observe in ETFs are what you would expect
from these very popular and useful investment vehicles. It is not
surprising to see increased volume near the close and when volatility
is high. The amount of the increase is consistent with the value these
securities provide investors and traders in managing their exposure to
the very real macroeconomic and political events that have driven
Ensuring a Quality Market for ETPs
Let me take a moment to comment on regulation. NASDAQ MarketWatch
and regulators at FINRA and the SEC monitor activity in all securities
traded or listed on the NASDAQ stock market, including ETPs. As I
inferred earlier, we support coordinating SRO, Broker, SEC and FINRA
policy to help answer the question: How can investors better understand
these products? Suitability and education should the underpinning of
this regulatory dialogue.
From a listing perspective the SEC's division of Trading and
Markets is deliberate and thorough in its review of new products. Aside
from new products that fall within the generic listing standards, in
other words ``plain vanilla'' index based products, sponsors are
required to submit a rule filing with the SEC through the exchange (in
the form of a 19b-4); the time to market is typically no shorter than 3
months and involves multiple rounds of comments between the Commission,
exchange and sponsor. Listing standards have evolved with new products
and will continue to do so; we are actively engaged with the SEC in
developing new listing standards to deal with new product developments.
The SEC and the exchanges have also partnered to look at trading
rules for all exchange traded assets including ETPs. Trading of ETPs is
protected by the same volatility protection provided for normal
equities. Following the 2008 and financial crisis and the May 6, 2010,
``Flash Crash'', NASDAQ OMX along with the other exchanges and the SEC
implemented two market-wide changes that limit the impact of volatility
on stock prices.
First, we have new short selling restrictions that are triggered
whenever a security's price falls more than 10 percent on a day. At
that point an order to sell short may not trade against bids,
preventing them from depleting demand for the stock. Since the short
sale rule was implemented in February 2011, ETFs are responsible for
less than 4 percent of the incidents of short selling restrictions,
despite making up about 14 percent of the listed securities in the U.S.
Second, all markets have adopted Single Stock Trading Pauses that
occur when a security's price moves rapidly over a 5 minute period. In
such a case the stock is halted for 5 minutes then re-opened with an
auction. Since the SSTP rule went into effect in June 2010, ETFs have
been responsible for just over 2 percent of all SSTP halts while making
up 14 percent of all securities. Since the SSTP rule was expanded to
cover a greater number of ETFs and other securities in August 2011,
ETFs have been responsible for less than 3 percent of all SSTP halts.
NASDAQ along with the other exchanges and the Securities and
Exchange Commission are working to upgrade from the Single Stock
Trading Pauses to a market-wide limit up limit down rule. Limit up
limit down rules proved effective in the futures markets during the May
6, 2010, ``flash crash.'' The advantages of a limit up limit down rule
are that it prevents trades at extreme prices before they happen and
then does not immediately go into a halt, thereby allowing the
continuous market to recover in many cases without the need for a
An important consideration for the limit up limit down rule is
interaction between price limits in individual stocks and limits in
securities that derive their prices from those individual stocks such
as ETPs. We are working with the other exchanges and the Securities and
Exchange Commission to control any unintended consequences of the rule
ETPs in the U.S. Are Different From Internationally Similar Products
Finally, we should examine the comparisons with foreign-issued
ETPs. I believe that the U.S. product design is superior. This is
especially true when comparing U.S. products with comparable European
products. Specifically, with derivative-based ETPs, in some cases, we
see that there is a vertical integration within the structure of the
products increasing the risk profile; this can be unknown to the
investor. The trading and creation flow of a derivative-based ETP has a
number of components: sponsor, exchange, market maker, and custodian
bank, to name some. In some cases, under the European UCITS (Europe's
equivalent of the Investment Company Act of 1940) structure, individual
firms are permitted to fulfill multiple roles within the construct of
the product's trading and or creation/redemption process. In other
words, the Sponsor/Issuer of an ETP could be the same entity as the
market maker, distributor, intraday NAV calculation agent, custodian
bank and counterparty to any underlying asset (swap or otherwise).
Under the Investment Act of 1940, this is not permitted. In the U.S.
construct, the Sponsor is tasked with securing independent third
parties to fulfill the different, critical roles, therefore mitigating
additional risks inherent in a vertical silo, European UCITS structure.
Additionally, as it relates to synthetic ETPs, the relationship
between the Fund Sponsor and the underlying derivative counterparty is
vastly different in the U.S. as compared to Europe. In Europe, when
entering into a swap, cash is delivered to the swap counterparty
(sometimes an affiliate of the sponsor) in return for collateral.
However, the return collateral is often uncorrelated to the fund
investment (particularly in unfunded arrangements) and in the event of
a default by the counterparty the fund is left with the risk of the
collateral basket and likely haircut in unwinding the collateral
assets. In the U.S., this risk does not exist. Instead, the sponsor
enters into a swap and delivers no cash to the counterparty; the cash
is put into a third party, independent custodian account, and is
invested in cash equivalents or money market instruments to
collateralize the swap. The accounts are governed by a tri-party
agreement. However the sponsor has authority and investment discretion
over the account. Consequently, there is no collateral risk as a result
of counterparty default.
Finally, there is a notable difference in transparency with respect
to ETP trading in Europe and the U.S. In the U.S., our national market
system mandates that all trades of 100 shares or more, both on exchange
and off exchange, have to be reported to the consolidated tape--
ensuring that all investors see the same transaction data for a given
security. In Europe's several jurisdictions, despite significant
efforts to unify securities rules across borders, all trades are not
reported to a central tape. Most ETP trades in Europe do not take place
on an exchange (they trade over-the-counter) and these trades are often
not reported in a timely fashion. There are obvious advantages for
dynamic price discovery when all activity in any security is visible to
the marketplace. As well, there are cautionary disadvantages that can
lead to serious market abuses when trades can be functionally hidden
from the market--and there are recent examples of the dangers inherent
in such a regime.
ETPs have grown in popularity because of their proven usefulness in
helping investors diversify and manage risk in today's complicated
markets. That popularity is reflected in daily trading activity, as it
should. But they do not dominate today's market. Their proportion of
trading is what you would expect when considering their usefulness.
During market volatility caused by explainable economic and political
events, we have seen no evidence that they increase in volume or
volatility beyond what we would expect. We believe that regulatory
community is well-positioned to monitor and discipline the growth and
innovation within this important category of financial products.
Thank you again for the opportunity to share our experience and
views about ETPs. I am happy to answer any questions you may have.
PREPARED STATEMENT OF NOEL ARCHARD
Managing Director, BlackRock I-Shares
October 19, 2011
Thank you Chairman Reed and Ranking Member Crapo for the
opportunity to appear today before this Subcommittee to discuss
Exchange Traded Funds (ETFs), which have become an important investment
product for investors large and small. My name is Noel Archard and I am
a Managing Director at BlackRock with responsibilities for product
development in our ETF business which operates under the name iShares.
BlackRock is one of the world's leading asset management firms,
offering clients a variety of equity, fixed income, cash management,
alternative investment, real estate, and advisory products. BlackRock
employs more than 9,700 people, including 5,500 in the U.S. Our client
base includes corporate, public, union and industry pension plans;
governments and official institutions; banks and insurance companies;
endowments, foundations and charities; and individuals.
BlackRock, through iShares, is the market leader in the ETF
industry both in the U.S. and globally, with iShares assets under
management in the U.S. of $470 billion and $632 billion globally. We
began managing our first ETFs in 1996 and subsequently launched the
iShares brand in 2000. We seek to provide financial products that serve
the best interests of our clients.
ETFs are one of the most dynamic and investor value-enhancing
market developments of the last 25 years. They offer investors a low-
cost, flexible and efficient way to invest in portfolios of stocks that
track indices and diversify portfolio risk.
While the first ETFs were straightforward, tracking relatively
broad benchmarks such as the S&P 500 or individual country indexes,
today some sponsors have introduced new products of increased
complexity that carry greater risk and may not be appropriate for
retail ``buy and hold'' investors. Products which raise such concerns
include so-called leveraged and inverse funds (described in greater
detail below), products that are backed principally by derivatives
rather than physical holdings. These products require a greater deal of
disclosure and up-front work with clients for them to understand
investment and structural risks and BlackRock believes that they should
not be labeled ETFs.
If there is one over-arching principle that we at BlackRock believe
should guide all participants in the growing ETF marketplace, it is
transparency in all aspects of the product structure. It is incumbent
on our industry and its regulators to ensure that investors who
purchase ETFs--and any financial product--know what they are buying and
appreciate the risk and costs associated with those products. That is
why BlackRock welcomes the focus of this Subcommittee on ETFs, as we
believe that more knowledge and more information about ETFs will
benefit investors and the general public alike.
In this vein, we have called for new standards for ETFs and
``Exchange Traded Products'' (ETPs) more broadly to enhance
transparency and investor protection. Clear labeling combined with
disclosure of fees and risks is a critical starting point to achieving
the better clarity investors need to understand various structures.
For the U.S. marketplace, BlackRock and iShares specifically
recommend the following:
Clear labeling of product structure and investment
A standard for funds using the ETF label to exclude from
that classification any leveraged or inverse products and any
primarily derivatives-based products currently described as
Frequent and timely disclosure for all holdings and
Disclosure of all fees and costs paid, and
Adoption of an ETF rule for the U.S. ETF market by the SEC
Clear and consistent product structure guidelines
Enhanced disclosure for higher risk products, and
Codification of routine exemptive relief that has been
granted multiple times over many years.
The Value of ETFs to Today's Investors
ETFs exist across a range of asset classes, including many not
readily available through other investment products, thereby permitting
investors to diversify their risk easily and efficiently by accessing
different areas of the global markets within one investment portfolio.
ETFs have made it convenient for investors to tailor a financial
portfolio based on their financial objectives.
In addition, by holding a basket of securities, rather than a
single stock or bond, ETFs represent broad diversification within an
asset class. Looking at ETFs trading on U.S. exchanges today, the top
50 funds by assets under management represent 60 percent of the ETF
market and overwhelmingly represent broadly diversified portfolios with
an average of 580 securities per fund.
Unlike traditional mutual funds, which are priced once daily, ETFs
trade like stocks, and, like stocks, can be traded throughout the day,
which provides increased investment flexibility to both professional
and retail investors.
Also, unlike typical mutual funds, which disclose their holdings
only quarterly and with a substantial time lag, most ETFs disclose all
or substantially all of their portfolio holdings frequently, often
daily, so investors can readily understand what they own.
ETFs utilize an innovative ``creation and redemption'' process
which helps keep an ETF's market price in line with the price of the
fund's underlying assets or net asset value per share (NAV). Through
the creation and redemption process, a group of certain broker-dealers
and market makers called ``authorized participants'' (APs) work with
ETF sponsors to (a) create new shares of an ETF if demand for shares in
the secondary market exceeds supply or (b) redeem shares if the
secondary market supply exceeds demand. APs generally manage the supply
of ETF shares by delivering the underlying securities that make up the
ETF to the fund in exchange for shares of the ETF, which the AP may
then make available for trading in the secondary market. This process
also works in reverse. APs can readily redeem a block of a specific
ETF's shares by gathering enough shares of the ETF and then exchanging
for the underlying securities held by the ETF. The creation and
redemption process not only helps the ETF trade in line with its
underlying value, but also reduces the portfolio turnover and related
transaction costs at the fund level, so that ETF investors are less
impacted by portfolio activity (as compared to a traditional open-end
Benefits Have Led to Rapid Adoption
Investments in ETFs by both institutional and retail investors has
increased year over year, with global ETF assets now estimated to be
$1.4 trillion, of which $969 billion is in the U.S. market. Each time
the financial markets and the financial industry has experienced a
severe disruption--the tech sector bubble bursting in 2000, the mutual
fund market timing scandals, the 2008 credit crisis, last year's
``Flash Crash'' and this year's credit crisis--ETF flows have
subsequently grown. This is because investors value the transparency,
efficiency and simplicity of ETFs.
Individual investors now use ETFs in a variety of ways: to build a
balanced portfolio through careful asset allocation, for example, or to
engage in tactical investing among sectors. ETFs help individuals
manage their investment costs, understand what they own and diversify a
portfolio. This in turn helps them build a nest egg, prepare for
retirement, or save for their children's education.
Institutional investors use ETFs for a variety of strategies as
well, including hedging and achieving exposure to otherwise difficult
to access markets. This helps institutions such as large pension plans,
foundations and endowments to manage their risks and meet their
Concerns Raised With the ETF Market Today
In the past few years, ETF sponsors have introduced increasingly
complex exchange traded products that in some cases have failed on
investors' expectations or failed to maintain appropriate standards of
transparency and simplicity. This has introduced new risks to investors
that may not be fully understood or, importantly, may not be
appropriate for long-term investors. Calling such products ETFs causes
investor confusion and regulators should require a different label.
Products which raise this concern include:
Daily-rebalance leveraged and inverse products
Products principally backed by derivatives rather than
While these products currently make up less than 10 percent of the
ETF assets in the U.S., they have generated created magnified and
questionable concerns about the role of all ETFs in the marketplace,
including ETFs that do not use inverse and leverage strategies or
invest principally using derivatives. Nevertheless, these concerns must
be addressed by the ETF industry and regulators in order to ensure the
benefits to investors provided by the majority of ETFs continue to be
Leveraged and Inverse Funds
As noted above, a specific type of derivatives-based ETF has
introduced further complexity by seeking to provide returns that are
(a) a multiple of the underlying index through the use of leverage
(which can magnify gains or losses) or (b) the inverse (or a multiple
of the inverse) of the underlying index (resulting in an ETF that
attempts to profit from the decline in the value of the underlying
Leveraged and inverse ETFs typically seek to maintain a specific
ratio of leverage to the benchmark each day and therefore have to
increase or decrease their exposure each day in response to market
movements. This daily rebalancing process keeps daily leverage at the
desired level, but over longer periods performance may be significantly
different than the unleveraged performance of the benchmark index
multiplied by the fund's specified leverage (or inverse leverage)
ratio. The use of leverage results in significantly different risks
than traditional ETFs, which should be clearly disclosed and reflected
in the name of the product category.
Use of Derivatives Rather Than Physical Securities
Much of global regulatory focus has been on, among other issues,
ETFs that use derivatives to replicate the performance of a given
benchmark rather than holding the physical assets (such as actual
stocks or bonds) that comprise that benchmark. Our view is that
physical-backed ETFs are typically a better choice for investors
because physical-backed funds provide investors with least amount of
risk relative to holdings in the fund--the fund is literally comprised
of securities fully owned by the fund with little or no counterparty
risk. We recognize that derivative-backed products can have a valid
role in an investor's portfolio when an underlying asset class is hard
to access or less liquid and therefore ETF exposure to the asset class
can only be provided efficiently through derivatives. It is important
to note that over 90 percent of the ETF assets in the U.S. today are
primarily backed by physical holdings.
Many questions have been raised over the past year regarding the
connection between the growth of ETFs and various market dynamics. Some
theories have tried to link macro-market volatility to the rise in
ETFs, while others have pegged end-of-day volatility to the use of
leveraged and inverse ETFs.
Our analysis of the data does not suggest that ETFs increase market
volatility. Any action that might be undertaken to address increased
market volatility would be counterproductive unless hard data shows
that ETFs in fact lead to increased market volatility. The historical
evidence available to us shows that the broad dynamics of market
volatility are reflective of overall macroeconomic uncertainty. Current
levels of volatility are not unprecedented and have been observed in
past periods of high macroeconomic uncertainty including well before
ETFs and other similar instruments were available in the market. During
periods of volatility, market participants look for mechanisms to trade
on broad economic and market news and ETFs provide an effective
mechanism to do so. This explains why we see increased ETF usage in
times of increased volatility, but that does not mean that ETF usage is
the cause of increased volatility. Indeed, all evidence suggests that
the primary cause of volatility lies with the fundamental macroeconomic
uncertainty that then gets priced into the market in the form of market
A number of questions have been raised about the role of leveraged
and inverse ETFs in creating end-of-day volatility. This should be
addressed in two parts. The first type of volatility we have seen in
the markets recently is when the market swings dramatically in opposite
directions near the close of the market. Leveraged and inverse ETFs
which rebalance daily must do so structurally in line with market
direction, meaning that when the market is down, they must adjust their
positions in the same fashion as the market (i.e., down) rather than
against it. Arguments put forward that instances when the market is
down 2 percent 15 minutes before the close and then up 2 percent at
market close are perpetrated by the presence of leveraged or inverse
rebalancing seems counter-intuitive.
A second type of the volatility focuses more on the potential for
leveraged or inverse funds to create a greater directional impact to
market moves in a particular direction (either up or down) at the
close. While it is possible that certain narrow market segments may be
impacted by such daily rebalancing activity, the fact that most
leveraged and inverse ETFs do not transact in physical securities
suggests that further analysis will be necessary before any conclusions
can be drawn about the impact of these types of funds on end-of-day
Recommendations for Reform of the ETP Marketplace
While ETPs all share certain characteristics, ``ETF'' has become a
blanket term describing many products that have a wide range of
different structures. This has led to confusion among investors. It is
important for investors to understand the differences among products
that are all described as ``ETFs'' despite exposing investors to
different types and levels of risk. The ETF industry today, both in the
U.S. and globally, is not doing a sufficient job in explaining those
Transparency is the one overarching principle that should guide all
participants in the ETF industry. When they were first introduced more
than two decades ago, ETFs helped bring a new level of transparency to
the financial industry. While most ETFs continue to provide clear and
transparent information about risks, holdings and fees, ETF
transparency can and should be improved for the benefit of investors.
This means transparency regarding the structure and risks of products;
transparency regarding the holdings of products; and transparency about
Like all securities, ETFs are regulated by various Government
agencies. Regulations, however, may need to further adapt to the rapid
changes in the marketplace. BlackRock believes that clarity of labeling
and what constitutes an ``ETF'' are essential and has made the
following recommendations to enhance investor protection. Our focus is
on ETFs that are index or passive vehicles--the vast majority of the
market--rather than active ETFs.
1. Clear Labeling of Product Structure and Investment Objectives
Investors should know what they are buying and what a product's
investment objectives are. This can be achieved by establishing a
standard classification system with clear labels to clarify the
differences between products. As previously noted, Exchange Traded
Product or ``ETP'' should be the broad term used to describe products
that trade on an exchange. ETF should refer only to a specific
subcategory that meets certain agreed standards. The attachment to this
statement summarizes our recommended classifications for exchange
At the most basic level, and with respect to what an investor
expects of an exchange traded fund, a product defined as an ETF should
mean that the product is regulated as a publicly offered investment
fund (in the U.S., a registered investment company regulated by the
SEC) and is appropriate for a long-term retail investor. Products that
are designed only for professional or short-term investors, such as
exchange traded products that use leveraged or inverse strategies,
would not be permitted to use the ``ETF'' label. Regarding derivatives
usage, any significant use of derivatives, including swaps, should be
clearly disclosed. This is why having an ETF rule that sets forth
consistent standards in the U.S. is so important.
BlackRock recognizes that different regulators around the world
have different views about what is permissible within a fund. U.S.,
European and Asian regulators, for example, are taking different
stances on the permissibility of using derivatives (including swaps) in
ETFs. A standardized classification system would benefit all investors
in understanding what they are buying, and such a system can also
assist regulators in developing appropriate rules in each jurisdiction.
Foreign regulators have already sought comment on addressing issues of
fund categorization for exchange traded products. We believe the SEC
should convene a working group of industry participants to agree upon
the criteria for a standardized classification system and then issue a
rule to assure uniform adoption. This type of classification will also
provide the necessary framework for other disclosure standards that we
believe are necessary as described below.
2. Frequent and Timely Disclosure of All Holdings and Financial
Just as investors should understand the structure of any exchange
traded product they are buying, they should also understand what that
product holds. To that end, sponsors should be required to provide a
clear picture of what the product holds and any of its other financial
exposures. Ideally, the goal should be daily disclosure of holdings and
exposures, but we recognize that there are currently practical,
technical and legal constraints that may prevent full disclosure of all
portfolio holdings in some products.
3. Disclosure of All Fees and Costs Paid
As some funds have become more complex, the fees associated with
some of them have also become more complex. Investors should have
complete clarity regarding all the costs and revenues associated with
any fund they buy, so they can clearly establish the total cost of
ownership. Thus, in addition to clearly stating the management fee paid
by the fund to the sponsor, the disclosure should include any costs or
fees that affect the investors' holdings and returns. For example, some
exchange traded products provide exposure to foreign currencies by
investing in non-U.S. dollar bank deposits, which may or may not pay a
market rate of interest. We believe that if investors are receiving a
return below the market rate of interest that is a hidden cost that
should be disclosed.
4. Adoption of an ETF Rule for the U.S. ETF Market by the SEC
The vast majority of ETFs traded in the U.S. are regulated under
the Investment Company Act of 1940 (the ``1940 Act''), the same as
mutual funds, but receive dispensations from the SEC so they can trade
on exchanges and create and redeem shares only with APs. Because ETFs
are a hybrid of conventional mutual funds and closed-end funds, they do
not fit neatly within the 1940 Act. As a result, in order for ETFs to
operate in the U.S., they must obtain exemptive relief from the SEC.
This exemptive relief can take years to obtain, and, as a consequence,
ETF sponsors may receive similar, but sometimes different, SEC relief.
It appears that a great deal of the SEC's limited resources devoted to
ETF regulation, however, are expended on what are now routine exemptive
applications for identical and/or substantially similar products from
different sponsors. Using as its foundation the ETF rule proposed in
2008, we urge the SEC to convene a public working group of market
participants to develop clear, consistent regulations for U.S. ETFs
that establish criteria for classification, take into account the ETF
transparency recommendations set forth above and promote the aspects of
the ETF market that create the greatest investor utility. In addition
to enhancing investor protection, this would create greater efficiency
for the SEC and promote competition.
We believe the SEC should, after consultation with ETF market
participants, adopt an ETF rule that provides uniform treatment of ETFs
and enhances disclosures, particularly for complex and higher risk
products such as leveraged and inverse funds. In our view, having
consistent rules applicable to ETFs in the U.S. would help investors to
better understand differences in these products and make more informed
As the global leader in exchange traded funds, BlackRock welcomes
the Subcommittee's focus on ETFs and related products. We explicitly
support uniform standards on labeling, transparency and disclosure that
will improve investor protection and help ensure that investors
understand precisely the risks and attributes of the ETFs they are
purchasing. BlackRock is committed to working with regulators, other
market participants, this Subcommittee and other policy makers to help
ensure that these important enhancements are made on a timely basis by
all participants in our industry.
PREPARED STATEMENT OF HAROLD BRADLEY
Chief Investment Officer, Ewing Marion Kauffman Foundation
October 19, 2011
Mr. Chairman, and Members of the Subcommittee, thank you for giving
me the opportunity to testify today about ETFs and the public policy
challenges they pose. I have prepared this written testimony with my
colleague at the Kauffman Foundation, Robert Litan, who is Vice
President for Research and Policy. I am Chief Investment Officer of the
Foundation. Both of us draw in this testimony on prior studies we have
done on the growing ETF market, \1\ by ourselves and with experts in
securities settlements. But we offer here supplemental information,
which we hope will be of use to this Committee. I will be delivering an
oral summary of this testimony at the hearing.
\1\ See, Harold Bradley and Robert E. Litan, ``Choking the
Recovery: Why New Growth Companies Aren't Going Public and Unrecognized
Risks of Future Market Disruptions'', http://www.kauffman.org/research-
and-policy/Choking-the-Recovery.aspx; and Harold Bradley and Robert E.
Litan, See, ``Canaries in the Coal Mine: How the Rise in Settlement
`Fails' Creates Systemic Risk for Financial Firms and Investors'',
Our bottom line is this: While ETFs began as a constructive
financial innovation over 18 years ago, they have grown so fast in
number and in variety that they now account for roughly half of all the
trading in U.S. equities markets today. In the process, in our view,
ETFs have increasingly distorted the role of equities markets in
capital formation, while posing systemic risks from potential
We outline below the basis for these admittedly controversial
conclusions, as well as some regulatory fixes to the problems we
ETFs and the Problems U.S. Equities Markets Today
Investors increasingly realize U.S. equity markets are broken. And
it isn't just amateur investors burned by the financial crisis of 2008
who think so. A recent New York Times article says professional U.S.
investors believe new derivative instruments ``have turned the market
into a casino on steroids.'' \2\
\2\ ``Volatility, Thy Name Is ETF'', New York Times. October 10,
What has gone wrong, and what are the consequences? It helps to
first remind ourselves why stock markets exist. They were established
to provide a place for companies to access public investment capital--
money invested to make more products, to hire more workers, to build
distribution networks around the world. That market no longer exists.
As is well known, modern stock markets are geared instead to day
traders, hedge funds and other short-term investors. Add to that list a
modern ``innovation'': Exchange Traded Funds (ETFs), which may be more
dangerous than all the preceding factors combined.
Here is why. The past 12 years reveal that fewer and fewer U.S.
companies elect to trade on primary U.S. stock markets. The number of
exchange-traded stocks dropped almost 30 percent--from about 6,200 to
4,300 today. During that same time, the Securities Exchange Commission
(SEC) gave ETF sponsors a free pass from certain U.S. securities
regulations. The predictable response? The number of ETFs grew
exponentially--eleven times--from 95 to more than 1,100 (Chart 1).
We have enough history with financial innovations to at least raise
questions when we see an innovation growing at very rapid rates. ETFs
are no exception. We believe that these instruments may now be
undermining the fundamental role of equities markets in pricing
securities to ensure that capital is efficiently allocated to growing
businesses. When individual common stocks increasingly behave as if
they are derivatives of frequently traded and interlinked ETF baskets,
then it is trading in the ETFs that is driving the prices of the
underlying stocks rather than the other way around. This tendency is
especially pronounced for ETFs that are comprised of small cap stocks
or stocks of newly listed companies, that generally are thinly traded.
The stocks of these companies are the proverbial tiny boats being
tossed around on the ETF ocean. As we outlined in our earlier Kauffman
Foundation report: ``Choking the Recovery: Why New Growth Companies
Aren't Going Public and Unrecognized Risks of Future Market
Disruptions,'' \3\ the reluctance to become such a little boat is an
important reason why growing private companies may be avoiding the
To understand why we reach this conclusion, it is useful to
understand the essential structure of an ETF. In the early days of the
industry, ETF sponsors now owned by BlackRock and State Street created
baskets of securities designed to track broad market indexes, such as
the S&P 500. In contrast, today's widely diverse ETF products cater to
every hedge fund's unique tastes. Product design allows hedge funds and
day traders to make bets on global uranium production companies, on
market volatility, on emerging market sovereign debt, and everything in
between. Embedded in some of these ETFs are even more derivative
Unlike mutual funds that price the basket of securities once daily
and allow for purchases and redemptions at that price, ETFs provide
continuous trading throughout the day. As electronic trading has
supplanted human specialists on the trading floor, the specialists and
market makers adapted and assumed the role as ``Authorized
Participants'' (APs) in manufacturing ETFs. When a customer buys shares
of an ETF, the AP serves as the middleman between all buyers and
sellers. If at any time during the trading session (and especially at
the end of the day) there are far more buyers than sellers, the AP
balances its books and buys shares in the underlying stocks of the ETF
basket--say lithium stocks--to create ETF units and offset its risk.
When there are more sellers than buyers, the AP must destroy these same
units by selling stocks or offset its risk by selling similar
instruments, like futures and options. On most days, buyers and sellers
nearly match--and the AP can go home and sleep well, hedged against
adverse price moves.
When buyers stampede into ETFs, the AP (now short the ETF to the
buyer) must quickly purchase related instruments or stocks to balance
his risk. An old adage of the trading business says that APs are in the
moving business and not the storage business--they are traders and
facilitators, never intending to be the beneficial owner of a stock.
This act creates extremely tight linkages between the movement of ETFs
and common stock prices. And the effect can be much larger on some
stocks than others, with some stocks being the largest holdings in many
different ETFs. For example, Apple Computer is reported to be one of
the top 10 holdings in more than 57 ETFs, IBM in 52 ETFs and WalMart in
30 ETFs. \4\ These same stocks are held in varying weights in dozens of
With the preceding mechanics in mind, it will come as no surprise
that there can be enormous one-way moves in ETF-driven stocks in very
short periods of time. This happened en masse in May 2010 during the
so-called Flash Crash (Chart 2), and again in October 2011 when stocks
experienced a ``Flash Up'' as the Russell IWM (Russell 2000 small cap
ETF) rallied almost 7 percent in the 20 minutes prior to the close
(Chart 3). This happens as buyers of futures and ETFs, generally
triggered by news or technical price patterns, all jump in the water at
the same time. The APs, who by regulatory requirements must provide
constant bid and ask prices for each ETF, then scramble to purchase
other closely related packages of the same securities or the underlying
High comovement of securities is not new, often occurring when
markets reflect crowd panic or euphoria. What is new, however, is how
ETFs decrease diversification benefits, with stocks and sectors
worldwide moving together, even when there is no panic. Stocks move
together today more than at any time in modern market history with
recent data indicating that individual common stock prices that make up
the S&P 500 index now move with the index 86 percent of the time (Chart
5 and Chart 6). As has been described, there are now so many products
consisting of the same common stocks that it would be surprising only
if this tight linkage was not evident.
ETFs only work if market makers can purchase component equities in
the index they intend to track. We think ETFs like the small
capitalization IWM have outgrown a market maker's ability to buy
component securities. Indeed, this particular ETF is reported to be one
of the top five stockholders in almost 900 small capitalization stocks
held in the IWM (Chart 7). As the one of us who is a former trader and
portfolio manager of small capitalization companies (Bradley) can
safely assert, most of these companies trade with poor liquidity and
will move significantly in price when immediate demands for liquidity
are made (Chart 8). Consequently, market makers can often only match
their positions against futures, options, or other ETFs, or they must
employ derivatives and synthetic securities. Perceived easy to trade
ETFs cannot ever make hard to trade stocks easier to buy or sell.
Absent easily accessible and liquid hedges for APs, investors must
anticipate that extreme stock price volatility will persist.
When financial assets move in highly correlated ways, regulators
should worry that capital markets are not doing their principal job--
that is, properly allocating capital between different assets or
financial instruments in such a way as to properly discipline risk and
reward success. J.P. Morgan's Delta One derivatives team published a
chart late in 2010 that displays the historically unprecedented
correlations found in today's stock trading which they term a
``correlation bubble'': in which stocks move together 60 percent of the
time even when the Volatility Index (VIX), a measure of panic, remains
at relatively subdued levels (Chart 8).
These are deep changes, with implications that go far beyond
whether IBM and, say, HP trade together. Richard Bookstaber, current
adviser to the Securities Exchange Commission staff and author of the
seminal 2007 book A Demon of Our Own Design, observes that ``(t)he
complexity at the heart of many recent market failures might have been
surmountable if it were not combined with another characteristic we
have built into markets, one that is described by the engineering term
tight coupling. Tight coupling means that components of a process are
critically interdependent; they are linked with little room for error
or time for recalibration or adjustment.''
The increasing comovement of individual stocks reflects the
intensity of trading in instruments whose total value and daily trading
volumes eclipse the value of the instruments they are designed to
``track'' (Chart 9). There is no time for an AP to call time-out to
calmly hedge one-sided trading markets. There is also no ability to
create liquidity where there isn't any, with liquid ETFs trading around
baskets of illiquid stocks. As assets balloon in ETFs, investors should
all worry about the disconnect between the size of these funds,
liquidity and possible market price disruptions in small company
stocks, commodities, bonds, and pretty much everything else.
Given all these risks, and given investor nervousness, why do these
instruments grow in popularity? Follow the money. Financial advisers
earn brokerage commissions every time they tactically allocate assets
in a client's portfolio by mixing and matching industry, sector and
country ETFs. The same advisers often promise clients an immediate
trading response to unexpected news or world events. Operating expenses
of some ETFs are lower than those of similarly invested mutual funds.
But far more important is that Investors have learned to love ETFs
largely for tax reasons because they are taxed like stocks: investors
only pay capital gains taxes if they sell the ETF for a higher price
than the one at which it was bought. In contrast, mutual fund investors
have no control over whether or not they pay capital gains taxes or
recognize losses, since these decisions are made by the manager of the
mutual fund. This explains why many mutual fund investors were shocked
to find out that they owed money on realized capital gains in 2008 even
though the net asset value of these funds dropped significantly that
year during the financial crisis (the managers held on to their losers,
but sold their winners). The pass through nature of taxes to mutual
fund shareholders may be the biggest driver of the rapid expansion of
assets under management in ETFs.
Innovations in nascent markets with small trading volumes often
attract moths to the flame with promises that often cannot be delivered
in times of market stress, or when the innovation becomes over-large.
Markets grow rapidly. They become more complex. Regulators have been
slow to react to this very profitable and fast growing niche of the
financial markets, one that may endanger capital formation by its very
The proliferation in the number and trading volumes of ETFs raise
larger concerns beyond just their potential impact on initial public
offerings. With ETFs making it so easy to effectively trade hundreds or
even thousands of stocks in fractions of a second, it is no surprise
that they are account for about half of all trading in equities
markets. ETFs make it so easy and inexpensive to translate investor
highs and lows into the entire market or large portions of it virtually
instantaneously. Thus it comes as no surprise, at least to us, that the
markets themselves have become so volatile, not only day to day, but
within each day.
Price volatility is scaring individual investors. It is not an
accident that mutual funds have seen such large net redemptions. These
investors are either going into ETFs, and thus perhaps unknowingly
contributing to market volatility in the process, or out of the markets
altogether in cash. In either case, the net result is not helpful for
long run economic growth.
ETFs have other more prosaic risks. They can be used easily in the
service of fraud, as was demonstrated recently when a single UBS
``rogue trader'' lost more than $2 billion on bad ETF trades that were
not properly hedged in the markets. Shortly before this event, we, and
two experts in securities settlement warned of potentially even greater
potential dangers if regulators remain lax about the industry's
policing of timely trade settlement. Increasingly, terms like ``create
to lend'' find their way into the lexicon of the ETF industry. Market
makers enjoy significant and historically arcane exemptions from rules
applying to trading and settlement that extend to all other market
participants--we worry these special privileges may lead to high levels
of trading ``fails'' and greater systemic risks to the overall market.
\5\ Such trading ``fails'' in ETFs during times of market stress could
domino into a greater systemic risk issue for our markets (Chart 11).
\5\ See, ``Canaries in the Coal Mine: How the Rise in Settlement
`Fails' Creates Systemic Risk for Financial Firms and Investors'',
March 2011, http://www.kauffman.org/research-and-policy/Canaries-in-
Time has proven that shorter settlement periods and high levels of
compliance are the best antidotes for systemic risks that might involve
the failure of a very large trading party. Congress specifies that
buyers of equities deliver cash and sellers of equities deliver
securities 3 days after a trade. When money arrives from buyers, but
the securities do not, a failure to deliver occurs. This happened
frequently in Government securities before large fines were imposed on
those failing to either receive or deliver a trade. Congress and the
SEC invested much time analyzing similar problems in naked short
selling of small capitalization stocks. So why then, in 2010, did two
of the biggest ETFs, the SPY (the SPDR S&P 500 TR ETF) and the IWM
(iShares Russell 2000 index ETF) constitute 21 percent of the failures
in the entire stock market (Chart 12)? Why would such broad indexes
with supposedly instant arbitrage characteristics fail to deliver in
such a significant manner? We fear that hedge funds and commercial
banks may be relying on lax enforcement of settlement rules to create a
cheap funding source for their trades--as has previously occurred in
other parts of the capital markets.
The industry argues that fails in ETFs don't really matter--that an
AP need only buy more physical securities to create necessary units and
relieve the failed trade settlement. We believe that to be a false
narrative. A cursory analysis of trading volumes in IWM component
securities indicates it would take more than 180 trading days, or more
than 6 months, trading at 10 percent of each stock's volume every day,
to offset reported short interest in that ETF. Attempts to purchase
these mostly hard to trade common stocks, held in very large
concentrations already by ETFs, will create sharp price movements up
and down. The math, given the current size of short positions, the
history of high settlement failure rates in ETFs, and the illiquidity
of many component stocks in the IWM, just doesn't work.
What Should Be Done?
We believe that, as Richard Bookstaber has warned, it is time to
recalibrate the regulation of our capital markets. That starts with an
emphasis on what's good for companies in our public markets rather than
what's good for trading volumes in the Nation's futures markets,
options markets and stock exchanges.
First, it is important for the SEC to begin to recognize some
fundamental differences in the risks posed to the market by price
volatility in stocks and ETFs. Take, for example, the circuit breakers
pioneered by the NYSE Euronext before the Flash Crash that created a
brief 5-minute trading halt for individual stocks that move more than
10 percent in price during the preceding five minutes. While this was a
surprise to competing exchanges that ignored the exchange's trading
halt and were forced to cancel large numbers of ``bad trades,'' the
NYSE Euronext canceled no trades as a result of this market anomaly.
Believing that ETFs and stocks are equivalent, the SEC recently
applied the same circuit breaker logic to ETFs. While this approach may
seem logical, it ignores the volatility-creating effect of ETFs
themselves, which to us, demands even tighter constraints on ETF price
movement than on common stocks. The essential characteristic of
portfolio construction is to achieve a diversification benefit; that
is, a single stock exhibits much higher volatility than does a
portfolio of stocks.
Said another way, a 10 percent movement of a broad based index
would necessarily imply far higher volatility in components of that
index. Consequently, we think the SEC should ask Self-Regulatory
Organizations (SROs) to require a circuit breaker time out whenever an
ETF moves more than 5 percent in the preceding five minutes. During
more than 17 years of trading history, 5 percent moves over an entire
trading session were rare; so a 5 percent constraint on short term
price changes should not interfere with day trading interests too much
and will keep ETFs in certain indexes or industries from overly
affecting the price behavior of component stocks on days like May 6,
2010 (Chart 10).
Second, we are concerned that after years of indifference to the
increasing comovement between indexes and common stocks regulators will
now put still worse ``fixes'' in place. Comment is being solicited on
the SEC's desire to restrict trading beyond fixed, arbitrary highs and
lows each trading session--what are called limit up, limit down
constraints on price movement for stocks and for indexes. These types
of trading constraints have been in place for some time at the Nation's
commodity exchanges where contracts trade on margin and such hard
limits have been used to collect additional margin on outstanding
At worst, while infrequent, these limits historically ``trapped''
traders on the wrong side of a move when markets move quickly and
remain frozen (for example, consider traders who sold short hard winter
wheat just prior to reports that the Chernobyl nuclear reactor melted
down). At best, such limit up, limit down rules serve as enormous
magnets to day traders. As markets approach daily price limits that may
suspend trading for either a brief time or for the day, customers
quickly cancel resting orders that stand in the way of the big waves,
awaiting a more opportune time to take the opposite side of the trade.
Often commodities that close ``locked limit up'' will ``gap'' open to
higher levels on the ensuing market opening before enticing sellers
back into the market.
Third, the SEC should reconsider its past policy of granting
blanket exemptions to ETFs from its rules governing mutual funds. We
are not advocating that ETFs be treated identically to mutual funds,
because clearly the two instruments are different. But a new regulatory
regime is called for, one that takes account of and ideally attempts to
mitigate the adverse impacts and risks of ETFs we have identified. At
the very least, the SEC should begin a broad inquiry into the nature
and magnitude of these impacts and risks with a view toward improving
its own and the public's understanding of the market-wide impacts of
these financial instruments.
In particular, we question whether market making exemptions are
really necessary in an age of high frequency trading and instantaneous
access to market liquidity. Questions should be asked about ETF
creation and destruction practices, about securities lending
operations, and the new ownership of ETF sponsors by custody banks
engaged in large lending operations. And regulators should investigate
the theoretical ``reason'' that explains away large outstanding short
ETF positions as easily ``covered'' in the cash markets, which appears
impossible from a cursory examination of the small capitalization IWM
ETF and a simple mathematical analysis of stock holdings and liquidity.
Fourth, in the interim, we suggest significant improvements into
the transparency of ETF construction and trading including the
consideration of the following prescriptions:
Require ETF sponsors to explicitly describe unit creation
and destruction processes in their prospectuses and summary
information, including provisions to align short interest in an
ETF with the liquidity of ETF constituents.
Require custodian banks to report each week fails-to-
receive and fails-to-deliver of equity and ETF securities in an
analogous fashion to the requirements imposed by the Federal
Reserve on primary dealers of U.S. debt securities. Eliminate
market maker exemptions and impose significant penalties or
fees for all transaction fails.
Establish broader fails reporting, including all
transaction activity for systemically important financial
institutions, especially primary custody banks, including:
Aggregate dollar value of securities lending pools by
asset class on a monthly basis so that investors and regulators
might anticipate shifts of the security supply and its
implications for market stability (as customers often cease
lending at the beginning of a serious liquidity crisis);
Fails-to-deliver (receive) securities and stratify by
Fails data according to custody bank business lines,
e.g., trading, securities lending, financing (repo services),
Thank you Mr. Chairman, and Members of the Committee, for allowing
me to present our views. I look forward to your questions.
RESPONSES TO WRITTEN QUESTIONS OF SENATOR HAGAN
FROM EILEEN ROMINGER
Q.1. I agree with Mr. Archard, who noted in his testimony that
it is important for the industry and its regulators to insure
investors who purchase Exchange Traded Funds (ETFs) appreciate
the risks and costs associated with those products.
Securities lending by ETFs exposes investors to a host of
complex risks that are not related to ownership of underlying
equities. I understand that securities lending is disclosed as
a risk in prospectuses, but what else could be done to ensure
that retail investors understands the risks associated with
A.1. The Commission and its staff are currently engaged in two
initiatives that may help investors better understand the risks
associated with securities lending by funds.
First, section 984(b) of the Dodd-Frank Wall Street Reform
and Consumer Protection Act requires the Commission to
undertake rulemaking to increase the transparency of
information available to brokers, dealers, and investors with
respect to the loan or borrowing of securities. In addition,
the staff of the Commission's Division of Investment Management
is currently reviewing the limitations and guidance applicable
to securities lending by funds (including ETFs).
In addition, while securities lending involves a number of
potential risks, there are particular regulatory requirements
applicable to ETFs and other funds registered under the
Investment Company Act that help to address these risks. For
example, registered funds may not lend out more than one-third
of their total assets. Loans must be 100 percent
collateralized, and the collateral must be marked to market
daily. Generally, only cash, securities issued or guaranteed by
the U.S. Government or its agencies, and irrevocable bank
letters of credit are acceptable collateral. Funds may invest
cash collateral only in short-term, highly liquid instruments.
In addition, common securities lending practice typically finds
many loans collateralized in amounts between 102 percent and
105 percent, and lending agents typically indemnify loans
against borrower default.
RESPONSES TO WRITTEN QUESTIONS OF SENATOR HAGAN
FROM HAROLD BRADLEY
Q.1. I agree with Mr. Archard, who noted in his testimony that
it is important for the industry and its regulators to insure
investors who purchase Exchange Traded Funds (ETFs) appreciate
the risks and costs associated with those products.
Securities lending by ETFs exposes investors to a host of
complex risks that are not related to ownership of underlying
equities. I understand that securities lending is disclosed as
a risk in prospectuses, but what else could be done to ensure
that retail investors understands the risks associated with
A.1. Senator Hagan asks an important question about securities
lending, where risk disclosures are now shrouded in dense
legalese and guided by decades of regulatory interpretation.
Risk disclosures should be as plain to investors as warnings
about cancer are to buyers of cigarettes. Today that language
confuses even sophisticated investors and should be
We discussed our concerns at the hearing on October 9,
2011, about the high percentage of failed trades in ETF
securities (more than 4 percent of principal dollars traded
versus .5 percent of dollars traded in individual securities).
It is apparent that off balance sheet securities lending and
re-hypothecation is to blame for the inherent instability in
the ETF marketplace. Many apologists for the high degree of
settlement failures site the role of the National Securities
Clearing Corp. (NSCC) as the ultimate guarantor of trades, much
as the Chicago Mercantile Exchange (CME) was thought to be the
ultimate guarantor of client funds in the MF Global bankruptcy.
We believe that the ETF marketplace, destabilized by trading
and securities lending interests, could reduce re-hypothecation
risk in the following ways:
Require ETF sponsors to publish in offering
prospectus the expected annualized tracking error of
all ETFs vis-a-vis the reference securities benchmark.
An explicit tracking error disclosure should then
become an obligation of the sponsor, in much the same
way that the Securities Exchange Commission (SEC)
obligates a mutual fund manager to manage funds
consistent with portfolio disclosures. For instance, a
mutual fund manager promising a ``global'' mandate must
own no more than 40 percent of assets in U.S. domiciled
securities. A manager promising a ``small
capitalization'' style must own more than 80 percent of
assets in that capitalization range. An explicit
tracking error disclosure would reveal immediately to
investors the very high risks of owning leveraged or
inverse ETFs, which rely necessarily on large
derivatives exposures, and thus have very large
expected annualized tracking error of 30 percent and
more against public securities benchmarks. Plain
vanilla indexes such as the S&P 500 should reveal very
low levels of expected tracking error (less than 2
percent). This would impose no burdens on quantitative
managers who rely on a variety of methodologies and
readily available software packages (e.g., Barra,
Northfield, Barclays Capital Live) to estimate ex ante
tracking error of quantitatively managed portfolios.
Once sponsors are held to explicit performance
obligations derived from product ``advertising,'' they
will then, in turn, obligate market makers to adhere to
tight tracking error standards. This should result in
timely ETF creation and destruction practices, thereby
reducing trading and re-hypothecation risk.
The SEC could further reduce systemic risks in
these processes by eliminating long-standing market
maker ``exemptions'' from securities and lending rules
governing other market participants. Such exemptions
have no role in today's highly automated securities
markets. The days of bicycles delivering stock
certificates in Wall Street's canyons and of pneumatic
tubes sending paper stock certificates from floor to
floor are long gone. So too, is the need for market
maker exemptions that were important before the days of
digital securities settlement.
Additionally, we suggest the following steps to better
protect investors from loss of principal involved in brokerage
transactions, such as those that occurred when principal
amounts in segregated commodity brokerage accounts were ``re-
hypothecated'' by MF Global in a series of bad sovereign debt
``repo'' trades. Our recommendations are in bullet form below
and we provide context and explanation below for our
recommended changes to regulation and law:
Hypothecation and re-hypothecation descriptions in
typical margin agreements should be written in easy to
understand language, along the following lines--
We have the right, at any time, to lend your
securities to subsidiaries and traders and to earn the
interest from that lending activity;
We will not pay you interest when we borrow your
These securities are often posted as collateral
by other traders for deals they have made with a
promise to pay at a later point in time; if those deals
go bad, you will lose the value of the securities that
have been lent as part of these deals;
When we borrow these securities from you, they
are most often used as collateral by others, meaning
they will be lost if the borrower makes a bad trade.
Restrict hypothecation and re-hypothecation; do not
allow firms to lend to subsidiaries subject to
different regulatory jurisdictions, as is believed to
have occurred in the MF Global debacle.
Require brokers to offer all investors with margin
accounts an ``opt-in'' to securities lending after a
plain English description of the activities to which
investors are bound; we think such an ``opt in'' will
likely create a strong incentive for brokers to share
compensation from such activities with clients.
The disappearance of segregated funds in the MF Global repo
mess bears some discussion in the context of our
recommendations. A Reuters securities law story based on
analysis by WESTLAW can be found at: (http://
hypothecation_scandal/). In part, it describes how related
company entities in different jurisdictions allowed for
disastrous regulatory arbitrage.
Puzzling many, though, were the huge sums involved. How
was MF Global able to ``lose'' $1.2 billion of its
clients' money and acquire a sovereign debt position of
$6.3 billion--a position more than five times the
firm's book value, or net worth? The answer it seems
lies in its exploitation of a loophole between UK and
U.S. brokerage rules on the use of clients' funds known
By way of background, hypothecation is when a borrower
pledges collateral to secure a debt. The borrower
retains ownership of the collateral but is
``hypothetically'' controlled by the creditor, who has
a right to seize possession if the borrower defaults.
In the U.S., this legal right takes the form of a lien
and in the UK generally in the form of a legal charge.
A simple example of a hypothecation is a mortgage, in
which a borrower legally owns the home, but the bank
holds a right to take possession of the property if the
borrower should default. In investment banking, assets
deposited with a broker will be hypothecated such that
a broker may sell securities if an investor fails to
keep up credit payments or if the securities drop in
value and the investor fails to respond to a margin
call (a request for more capital).
Re-hypothecation occurs when a bank or broker re-uses
collateral posted by clients, such as hedge funds, to
back the broker's own trades and borrowings. The
practice of re-hypothecation runs into the trillions of
dollars and is perfectly legal. It is justified by
brokers on the basis that it is a capital efficient way
of financing their operations much to the chagrin of
hedge funds. [Emphasis added.]
Under the U.S. Federal Reserve Board's Regulation T and
SEC Rule 15c3-3, a prime broker may re-hypothecate
assets to the value of 140 percent of the client's
liability to the prime broker. For example, assume a
customer has deposited $500 in securities and has a
debt deficit of $200, resulting in net equity of $300.
The broker-dealer can re-hypothecate up to $280 (140
percent x $200) of these assets. But in the UK, there
is absolutely no statutory limit on the amount that can
be re-hypothecated. In fact, brokers are free to re-
hypothecate all and even more than the assets deposited
by clients. Instead it is up to clients to negotiate a
limit or prohibition on re-hypothecation. On the above
example a UK broker could, and frequently would, re-
hypothecate 100 percent of the pledged securities
($500). This asymmetry of rules makes exploiting the
more lax UK regime Incredibly attractive to
international brokerage firms such as MF Global or
Lehman Brothers which can use European subsidiaries to
create pools of funding for their U.S. operations,
without the bother of complying with U.S. restrictions.
We find the current disclosure practices of U.S. brokerage
firms about securities lending practices to be appalling in
terms of complexity and obfuscation. Listed below is an example
of language regarding securities lending lifted from a Web site
of Scottrade (www.scottrade.com) and is typical of such
Pledge of Securities, Options, and Other Property. All
securities and other property now or hereafter held,
carried or maintained by us in or for your Account may,
from time to time without notice to you, be pledged,
repledged, hypothecated or re-hypothecated by us,
either separately or in common with other securities
and other property . . . Any losses, gains or
compensation resulting from these activities will not
accrue to your brokerage Account. We are required under
SEC rule 15c3-3 to retain in our possession and control
all fully paid-for securities. Securities used as
Collateral for Margin Loans are not fully paid for and
therefore are not subject to the same obligation.
Loan of Securities. We are authorized to lend
ourselves, as principal or otherwise, or others any
securities held by us in your Account and we shall have
no obligation to retain under our possession and
control a like amount of such securities. In connection
with such loans, we may receive and retain certain
benefits (including interest on collateral posted for
such loans) to which you shall not be entitled. In
certain circumstances, such loans may limit, in whole
or in part, your ability to exercise voting rights of
the securities lent.
In the E*TRADE ``Managed ETF Portfolio Agreement and
Advisory Agreement,'' investors are compelled to sign an
agreement that says, among other dense legal acknowledgements,
that the investors ``acknowledge that securities held in a
Margin account may be pledged, re-pledged, hypothecated or re-
hypothecated for any amount due E*TRADE Securities, LLC, in
account(s) or for a greater amount . . . Securities products
and services: (i) are not insured by the FDIC; (ii) carry no
bank or Government guarantees; and (iii) are subject to
investment risks, including possible loss of principal
Senator Hagan, the only way to better inform retail
investors about the risks associated with securities lending is
to overhaul both disclosure and hypothecation rules long in
force in our Nation's securities markets. Securities lending is
an under-regulated, less than opaque part of the earnings
stream of major broker dealers and investment banks.
Thank you for your interest in this area.