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Sounding ETF Smoke Alarm

Written by Alex Ulam

 –  October 21, 2011

Ulam: You also have expressed concerns about ETFs and correlations between prices of different stocks.

Litan: We have looked at the very high correlations of ETFs to each other. And the movements of stocks also are increasingly correlated with each other. And this is very unusual because you would expect stock movements to be correlated when everyone is panicking. But the market is not in a panic mode right now, and yet we have very high correlations. And so, we draw an inference that one reason for these correlations has to be that people are trading in and out of the market with ETFs. That would explain why all the stock prices would be very highly correlated.

Ulam: How would you propose regulating ETFs?

Litan: There are several ideas that we have advanced. On the small-cap problem, you could do one of two things. You could first make it illegal for an ETF to have small-cap stocks in it. That is obviously a more extreme thing to do. But a less extreme thing would be to say that a small-cap ETF cannot have a small-cap stock in it unless it pays the company for the right to include it in the index. Because as it is now, you go public and anyone can put it in an index—basically you lose control of your stock. One argument is that the decision must be at least left up to the company rather than to the ETF sponsor.

Ulam: But then you would have to do that for all companies?

Litan: The small-cap problem is a small-cap problem. ETFs are not driving the price of Apple or Microsoft.

Ulam: So how do you propose regulating large-cap stocks?

Litan: Right now there are circuit breakers for individual stocks that were enacted after the flash crash. At a 10 percent price movement, there is a trading halt. We argue in the testimony for tighter circuit breakers for ETFs—maybe 3 or 4 percent, because a 10 percent movement for an ETF means a tremendous movement for a lot of the underlying stocks. So we think that applying the same 10 percent movement rule to an ETF really is not right; you should probably apply a much more restrictive rule, and that could reduce some of the extreme volatility of the ETF movement. I don’t know what else to do about this. We are not going to eliminate ETFs, but I think we can at least limit our susceptibility to ETFs’ wild swings. The circuit breakers could flip in at 3 or 4 percent.

Ulam: Does the SEC seem like it is receptive to your suggestions?

Litan: I think that it is time for the SEC to be doing some fundamental research into this and also to be doing a fundamental rethink about their approach to market volatility. We just see enough smoke. I am not going to say that we have a smoking gun. I am not going to make that claim. But there is enough smoke out there that people ought to be concerned about this. Another point, which is not in our testimony, is that there are ETFs out there that are composed of derivatives.

That means that the ETF is dependent upon the soundness of the underlying counterparty. And that begins to sound like CDO [collateralised debt obligations] —and I don’t like to invoke the “CDO” word, but that is basically what CDOs were. You have CDOs and synthetic instruments. I get worried when you start building derivative on top of derivatives because ultimately all ETFs are derivatives.

Ulam: Why do you think that all ETFs are derivatives?

Litan: Because all of their value is derived from the underlying stocks. As a matter of technical precision, they are a derivative because their value is derived from something else.




Europe Blog

Thursday, April 12, 2012 17:34 (CET)

Posted By Paul Amery

Paul Amery

Is the intraday tradeability of ETFs a blessing or a curse?



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