[Senate Hearing 112-400]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 112-400

 
   MARKET MICROSTRUCTURE: EXAMINATION OF EXCHANGE-TRADED FUNDS (ETFs)

=======================================================================

                                HEARING

                               before the

                            SUBCOMMITTEE ON
                 SECURITIES, INSURANCE, AND INVESTMENT

                                 of the

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                      ONE HUNDRED TWELFTH CONGRESS

                             FIRST SESSION

                                   ON

                 EXAMINING EXCHANGE-TRADED FUNDS (ETFs)

                               __________

                            OCTOBER 19, 2011

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs


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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

                                  (ii)



                            C O N T E N T S

                              ----------                              

                      WEDNESDAY, OCTOBER 19, 2011

                                                                   Page

Opening statement of Chairman Reed...............................     1

                               WITNESSES

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 
  OMX............................................................     6
    Prepared statement...........................................    34
Noel Archard, Managing Director, BlackRock I-Shares..............     8
    Prepared statement...........................................    42
Harold Bradley, Chief Investment Officer, Ewing Marion Kauffman
  Foundation.....................................................    10
    Prepared statement...........................................    47
    Responses to written questions of:
        Senator Hagan............................................    63

                                 (iii)


   MARKET MICROSTRUCTURE: EXAMINATION OF EXCHANGE-TRADED FUNDS (ETFs)

                              ----------                              


                      WEDNESDAY, OCTOBER 19, 2011

                                       U.S. Senate,
     Subcommittee on Securities, Insurance, and Investment,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.
    The Subcommittee convened at 9:32 a.m., in room SD-538, 
Dirksen Senate Office Building, Hon. Jack Reed, Chairman of the 
Subcommittee, presiding.

            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 
insights.
    Let me welcome everyone here to the hearing entitled 
``Market Microstructure: Examination of Exchange-Traded 
Funds.''
    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 
derivatives.
    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 
market swings.
    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 
proceed.
    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.
    [Laughter.]
    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 
insights.
    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 
begin.

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.
    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 
whole.
    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 
proceed.
    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 
Americans invest.
    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 
trading day.
    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 
index.
    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 
rule.
    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-
                             SHARES

    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 
portfolio.
    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 
grew exponentially.
    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 
portfolio manager.
    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 
securities.
    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 
public companies.
    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. 
Forgive me.
    [Laughter.]
    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, 
et cetera.
    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 
buying.
    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 
the SEC?
    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. Bradley.
    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 
experience.
    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 
my concern.
    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 
all around----
    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 
fewer gifts.
    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 
going----
    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 
dissuading investors.
    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 
capital formation.
    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 
formation.
    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 
stated.
    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, 
but----
    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 
that fair?
    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 
your comments?
    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----
    [Laughter.]
    Mr. Archard. Much easier.
    Chairman Reed. Actually, in Rhode Island, it is pronounced 
No-ell, but----
    [Laughter.]
    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 
it.
    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 
in those.
    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 
correlations.
    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 
effect.
    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 
time.
    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 
problem.
    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 
have.
    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 
maker exemption.
    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 
forward.
    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 
                               Commission
                            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/
Financial%20Developments.pdf.
---------------------------------------------------------------------------
    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 
managed ETFs.

    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 
1940 Act.

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 
million dollars.
    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 
position.
    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 
        Offices
    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 
(Exchange Act).
    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 
listing requirements.
    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 
the product.
    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\
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     \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.
Synthetic ETFs
    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 
analysis.
---------------------------------------------------------------------------
     \4\ See, Financial Stability Oversight Council Annual Report 2011 
at 66-67, available at http://www.treasury.gov/initiatives/fsoc/
Documents/Financial%20Developments.pdf.
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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.
SEC Initiatives
    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.
Conclusion
    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.
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     \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.
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    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 
BX.
    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 
Europe.
    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 
instruments.
    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 
turbulent atmosphere.
    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 
index.
    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 
markets recently.



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 
complete halt.
    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 
on ETPs.

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.

Conclusion
    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 
        objectives

      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 
        ``ETFs''

    Frequent and timely disclosure for all holdings and 
        financial exposures

    Disclosure of all fees and costs paid, and

    Adoption of an ETF rule for the U.S. ETF market by the SEC 
        encompassing:

      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 
mutual fund).

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 
financial obligations.

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 
        physical holdings

    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 
realized.

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 
benchmark).
    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.

Market Volatility
    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 
volatility.
    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 
volatility.

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 
differences consistently.
    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 
fees charged.
    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 
traded products.
    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 
        Exposures
    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 
investment decisions.

Conclusion
    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'', 
http://www.kauffman.org/research-and-policy/Canaries-in-the-Coal-
Mine.aspx.
---------------------------------------------------------------------------
    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 
settlement failures.
    We outline below the basis for these admittedly controversial 
conclusions, as well as some regulatory fixes to the problems we 
identify.
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, 
2011.
---------------------------------------------------------------------------
    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 
public markets.
---------------------------------------------------------------------------
     \3\ http://www.kauffman.org/research-and-policy/Choking-the-
Recovery.aspx
---------------------------------------------------------------------------
    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 
instruments.
    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 
other ETFs.
---------------------------------------------------------------------------
     \4\ www.etfdb.com
---------------------------------------------------------------------------
    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 
stocks themselves.
    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.

ETF Risks
    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 
design.
    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-
the-Coal-Mine.aspx.
---------------------------------------------------------------------------
    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 
bargains.
    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 
        customer segment;

      Fails data according to custody bank business lines, 
        e.g., trading, securities lending, financing (repo services), 
        etc.

    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 
securities lending?

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 
securities lending?

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 
dramatically simplified.
    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 
        securities;

      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://
newsandinsight.thomsonreuters.com/Securities/Insight/2011/12_-
_December/MF_Global_and_the_great_Wall_St_re-
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 
        as ``re-hypothecation.''

RE-HYPOTHECATION

        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.]

U.S. RULES

        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 
disclosures:

        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 
invested.''
    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.
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